Fixed Income Weekly

Risky assets, including stocks and corporate bonds, experienced a substantial recovery in 2009. The same investors who flocked to Treasurys at the height of the credit crisis in 2008, shunned them for riskier investments as the panic subsided. The Fed kept policy ultra-loose throughout the year and kept rates very low, buying $1.086 trillion in Agency MBS and $300 billion in Treasurys through their quantitative easing programs.

A graph of where we stand rate wise. (intraday 12/31/09)

Treasury Issuance
Heavy supply concerns dominated much of my commentary during 2009, but supply actually had very little effect on the rate environment. The Treasury auctioned just under $2.2 trillion in coupon Treasurys in 2009 ($2,195,836,163,400 to be exact). That was a 113% increase from the year before and growth is showing no sign of stopping in 2010. Claims that the US will soon be replaced as the world’s reserve currency were also prominent this past year, causing many to think that the abundance of foreign buyers of US debt will soon be a thing of the past. But the US relies on foreign buyers of debt no more than those same countries rely on the strength of the Dollar to support their export dominated economies. So don’t expect radical changes to the landscape any time soon.

Credit
Investment grade credit was outdone only by non-investment grade credit in 2009. CSJ (1-3 year credit) outperformed LQD (12 year credit) on a price only basis due to rates moving higher, but LQD barely beat out CSJ when you factor in interest income. For 2009 CSJ was up 3.09% price only and 7.08% total, while LQD was up 2.46% and 8.46% respectively. They both massively underperformed HYG (High Yield Corporate Bond) which returned 28.5% in 2009.

This year’s strong rally in credit was still only a partial reversal of damage done in 2008. By most measures credit spreads are sill wider than they were before the crisis began, but absolute yields are still lower, which is very accommodative to corporations looking to borrow.

Credit Default Swaps, which are used as insurance against a default, followed the rally in corporate bonds in 2009. According to Markit the cost of default protection on a broad basket of corporate debt fell 63% in 2009 to 85 basis points. The cost is quoted as an annual payment based on a percentage of the the notional amount insured.

2010?
So what’s in store for bonds in the New Year? The Fed still has about $200 billion in MBS to purchase, which should be completed by March. Expectations for Treasury issuance in 2010 vary from “as much as humanly possible” to “even more than that”, and rates are likely to edge higher throughout the year as the fed begins to signal a policy reversal in the second half of 2009. Fannie and Freddie are all but entirely owned and run by the Government, so subsidies to homeowners will likely continue even after the tax credit expires at the end of April and the credit quality of their bonds will likely continue to move closer to that of Ginnie Mae. And based on Bernanke’s demeanor and the Fed’s recent language my expectation is for them to move more than 25 basis points on the Fed Funds Target rate (to .75% maybe?) by Q3 2009 (at their September 21st meeting maybe?) after removing the remainder of their emergency liquidity and repo programs by the summer.

Happy New Year Everybody!!

Cliff J. Reynolds Jr., Investment Analyst