Keith M. Berlin
Vice President
Michael J. O’Connor
Research Analyst
“Higher quality investment grade corporate bonds outperformed lower quality bonds.”
FIXED INCOME
The Barclays Capital Aggregate Bond Index (BCAG) gained 0.8% in May. Within the largest components of the index, Treasuries were the strongest performing sector, gaining 1.5%, as investors pursued quality investments and credit spreads widened. Agency mortgage-backed securities also outperformed the benchmark, gaining 1.2%. Investment grade commercial mortgage-backed securities, a smaller part of the BCAG, underperformed the index during the month, declining 1.5%. Investment grade credit also underperformed the index, losing 0.4%. In the credit sensitive areas, high yield bonds lost 3.6% while bank loans fell 2.1%. Within international bonds, emerging market debt underperformed U.S. Treasuries on both a hedged and un-hedged basis, as the dollar strengthened versus developed and emerging market countries during a “flight-to-quality” environment.
Treasuries and TIPS
The U.S. Treasury yield curve remained steep, although yields on the long end of the curve continued their decline (prices rose) while the front end was static. As such, long-dated Treasuries gained 4.3% while intermediate Treasuries only gained 1.3%. Increasing sovereign debt concerns, particularly in the euro zone, led investors to seek the relative quality of U.S. Treasuries and the U.S. dollar. Following a strong performance in April, TIPS underperformed nominals during May, with a flat return, as investor concerns about future inflationary pressures eased.
Agency Mortgage-Backed Option-Adjusted Spreads Continued to Tighten
Agency mortgage-backed securities outperformed the BCAG during the month, as the safety of the government’s support outweighed unattractive spreads relative to other spread sectors. Option-adjusted spreads tightened during the month and remained below historical averages. As a result, investors seeking additional yield have been attracted to other areas of the fixed income markets, such as non-agency residential mortgage-backed securities and commercial mortgage-backed securities. Many fixed income managers continue to underweight agency mortgages as they wait for the opportunity to increase their exposure back to a market weight once option-adjusted spreads widen.
Investment Grade Credit
Higher quality investment grade corporate bonds outperformed lower quality, with AAA-rated bonds gaining 0.7% while BBB-rated bonds lost 0.9%. Within the key sectors of investment grade corporates, utilities lost 0.2%, industrials fell by 0.1%, and financials were down 1.4%. Investment grade corporate spreads widened by 50 basis points on the month, moving back above their historical averages.
Credit Markets Have Begun to Cool
The high yield and bank loan markets underperformed the broader market in May. Appetite for risk decreased as a “flight to quality” environment unfolded with CCC-rated bonds losing 5.5% and BB-rated bonds losing 3.0% in May. Bank loans declined, but less so than high yield, as moving up the capital structure migrated some of the loses.
