FIXED INCOME COMMENTARY

SECOND QUARTER, 2010

Global fixed-income markets began the second quarter with ongoing concerns about the debt of developed European nations, namely Greece, Portugal, Spain, Ireland and Italy. Greece’s benchmark 10 year bond yield started the quarter at 6.53%, climbed to 12.43% in early May before retreating almost five percentage points upon the avoidance of default in May. However, the decline was short-lived. At quarter’s end, the yield stood at 10.55%. In stark contrast, yields in stronger developed countries such as the United States and Germany moved in the opposite direction. The US Treasury’s 10 year bond yield began April at 3.84%, reached 4% shortly thereafter and then retreated steadily to end the quarter at 2.97%. These are some of the lowest yields we’ve seen since April, 2009 when yields bottomed at levels not experienced since the 1950s. These anecdotes were emblematic of investor appetite for fixed-income during the quarter -- a flight from perceived risky assets (Greek, Portuguese, Spanish, Italian and Irish sovereign debt) to perceived “riskless” assets (US Treasuries, German Bunds, etc.)

Sovereign Bond Yields for Q2 2010

Source: Bloomberg

Holding period returns exemplified the aversion to risk during the quarter. The 10 year US Treasury was up 8.48% whereas a hedged portfolio of developed international sovereign debt returned just 2.26% because of the “risk” associated with several aforementioned members of the developed world. Developing market sovereigns appreciated 1.43% while three month Treasury bills returned an anemic 0.04%. The US high yield market fared worse, declining 0.07%. Similarly, despite hefty coupons, emerging market corporate debt delivered a return of -0.99%. Clearly, the farther down the risk spectrum investors ventured, the worse their portfolio’s performance.

Flight to Quality

Developing market debt delivered modestly negative returns in the face of several headwinds. The traditional macro drivers of developing nation debt all moved in the wrong direction: oil prices fell nearly 11 percent, commodities dropped five percent and the US Dollar rose six percent. Default rates in this sector continued to be at negligible levels with spreads to their developed world counterparts remaining attractive, suggesting that value still exists in these securities. Despite a hiccup in the second quarter however, developing market debt was one of the few asset classes to post positive returns for the first half of 2010.

Price/Index Performance

Source: Bloomberg

In the developed sovereign debt sector, as the quarter drew to an end, focus on Greece was starting to ebb, instead shifting to Spain and Portugal. Additionally, a slowdown in Chinese growth and increased concerns of a “double-dip” in global economic activity were front and center as economic indicators started to reverse their recent, upward trends. Consumer concerns about their economies started mounting once again, equity markets experienced sharp declines and government bond yields resumed their decline.

As the third quarter begins and we look to the balance of the year, tough economic times lie ahead. Several western European nations have announced austerity measures, unemployment rates remain stubbornly high and the consumer remains stretched. Speculation is rampant as to the “true expense” of the unprecedented liquidity injected into developed economies during the last two years. Will the US Dollar lose its safe haven status? Will the Yen retain its strength despite unprecedented levels of outstanding Japanese debt? Will the Chinese be able to maneuver a soft landing or will their economy suffer a collapse, as some predict? Will higher inflation in emerging economies moderate or will it be necessary to further tighten fiscal and/or monetary conditions? Are we beyond the risk of a sovereign default? Stay tuned. Irrespective of the camp one may be in, we believe spreads between developing and developed nation debt will continue to contract and that country selection will be the key to successful global debt investing.

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