After a relatively sleepy start to the quarter, the taxable fixed income markets went on a quick rollercoaster ride for the final 60 days of the year.
The Treasury yield curve dipped in November, sharply in the case of the 2-10 year portion of the curve, and then jumped in December wiping out any gains for the quarter .
The Barclays Treasury Index was down 3.6% for the year after being up 13.7% in 2008. Despite the shift in the Treasury yield curve both the corporate bond market and the MBS market managed gains in the quarter to add to already impressive years. The Barclays Corporate Index was up 1.4% in the quarter, finishing the year with an 18.7% return and handily wiping out 2008's 4.9% loss.
Within the corporate sector, all three segments (Industrial, Financial, Utility) had positive returns in the fourth quarter, but the Financial sector (+2.6%) was the only sector return greater than one percent. This sector is still playing catch up after lagging during the first part of the rally early in 2009.
The high yield segment of the market closed out its best year ever, with the Barclay's U.S. High Yield Index up 6.2% in the final quarter and 58.2% for the year. Prima interviewed a number of managers in this space during the fourth quarter and most do not believe the current fundamentals support the price action that has occurred in the lower rated credits in 2009. The end result will likely be a focus on higher rated credits, or at least more fundamentally sound credits.
Default rate assumptions have also come down, with most managers believing that defaults have peaked at 12-13% and will very gradually fall back to normal.
The short end of the Municipal spectrum had a slightly positive fourth quarter, but maturities longer than seven years in general fell during the period. This was particularly true at the very long end, as the Barclays 20 Year Municipal Index was down 2.4%.
Overall though, the muni market had a very good year, with returns rising with maturities. The managers Prima spoke to during the quarter believe a significant portion of the losses in the quarter were due to profit taking for the year and dealers clearing inventory off the books prior to the end of the year.
The municipal market has a number of advantages which should create a positive environment for the first half of 2010. The current yield advantage over Treasuries on a nominal basis will create an incentive for non-traditional buyers to remain in the municipal market until yields are driven significantly lower.
The continued issuance of Build America Bonds, federally backed municipal issues, may limit new issuance in 2010 particularly at the long end of the maturity spectrum. Finally, even the potential for rising tax rates could significantly stimulate demand.
Nathan Behan is a senior investment analyst at Prima Capital Holding Inc., a provider of investment research, technology and portfolio design to the wealth management and retirement industries.
