FIXED INCOME COMMENTARY

WINTER 2010-2011

2010 can best be characterized by a continued chase for yield by the aging populations of the developed nations of the world. Emerging market corporate debt, perhaps the “riskiest” of the asset classes, returned in excess of 22 percent with US high yield market coming in a distant second with an appreciation of nearly 13 percent. Developing country sovereign debt was close with a 12 percent return followed by nearly a 10 percent return on 10 year US Treasury Notes. International developed sovereign debt experienced a total return of just over three percent reflecting the unrest in several of the developed nations, namely Greece, Portugal, Spain, Ireland and Italy. US Treasury bills, reflecting their ultimate safe haven status, returned a paltry 12 basis points.

Chase for Yield

As we begin 2011, concerns about the fate of some European nations and the impact of their deteriorating conditions on the viability of the Euro continue to be reflected in the price of their credit default swaps (CDS). The five nations that experienced the greatest percentage increase in the price of insuring their sovereign debt in 2010 are depicted below. With one significant exception (Japan), the other four nations are based in continental Europe. Monitoring the CDS values can provide important insight into investor thinking, the risk associated with each nation’s debt and often a signal as to when the tipping point is reached.

Increased Credit Default Swap Rates

Source: Bloomberg

In stark contrast to the nations identified above, countries experiencing the greatest decline in the price of insuring their debt are identified below. Ironically, despite running considerably higher deficits and issuing record level of debt, the United States’ CDS rates actually declined by over nine percent. Had it not been for its world reserve currency status, the outcome may have been quite different.

Decreased Credit Default Swap Rates

Source: Bloomberg

Developing market debt experienced strong returns as their economies recovered more quickly than their developed economy counterparts in the aftermath of the financial tsunami of 2008/2009. The traditional macro drivers continued to provide favorable tail winds: commodities broadly rose 17% and oil specifically, was up over 8 percent. Although the US Dollar Index improved modestly (2.2%) during the year, against a basket of major emerging market currencies, the dollar actually declined about 4%. A stronger macroeconomic backdrop and the injection of liquidity via a second quantitative easing by the Federal Reserve (QE2) further fueled demand for developing market assets to record levels.

Price/Index Performance

Source: Bloomberg

As the New Year unfolds, developing market fundamentals continue to be very strong compared to those of developed nations. According to the International Monetary Fund (IMF), in 2011, government debt will probably amount to 37% of emerging market gross domestic product and budget deficits are likely to be in the three percent range. Conversely, the comparable numbers are likely to be 101% and 6.7%, respectively, in advanced nations. The IMF is further projecting that emerging economies could expand at a 6.4% rate in 2011, nearly three times the 2.2% rate for developed nations. Such growth in developing economies however, is likely to come at the expense of higher inflation and central bank headwinds.

To conclude, we believe caution is warranted with developing nation debt spreads having contracted significantly during the last 12 months. Country selection will be the key to successful investing in 2011. Headline risk, as has recently been the case with Belgium, should be avoided as this may result in considerable, albeit temporary, impairment. Portfolios should be over-weighted in debt exhibiting: improving CDS rates; nations addressing their deteriorating 4 finances by implementing austerity measures; and, countries whose central banks are willing to tighten fiscal and/or monetary conditions to fight inflationary pressures. Finally, durations should be managed to the short end of investment policy ranges.

Although debt markets may take a breather during the year and deliver midsingle digit returns, we believe that over the longer term, the fixed-income asset class will continue to benefit from the aging demographics of the developed nations and their insatiable appetite for income.

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