Fixed Income In 2011: The Year Of Opposites

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December 20, 2011 4:27pm NYSE:AGG NYSE:HYG

Matt Tucker:  Expectations of rising interest rates. Fears of massive municipal bond defaults. Heading in to 2011, those were the two strong trends that investors expected would shape the fixed income market. But as we know now, 2011 turned out to be almost the opposite of expectations.

At the end of 2010, investors were positioning their portfolios to respond to rising interest rates. To hedge rising interest rates in the first three quarters of the year, investors turned to fixed income ETFs, moving into short duration funds or investing in leveraged and inverse funds. Leveraged and inverse fixed income funds almost doubled in size by September1.

But contrary to expectations, rising interest rates never materialized. The Federal Reserve kept its benchmark Funds rate near 0% and in August communicated for the first time that it intended to keep rates between 0% and 0.25% until 2013.

This was an unprecedented move on the part of the Fed. Previously they had communicated changes in the Fed Funds rate, as well as their view on the economic outlook and the likely path the Fed Funds rate would take in the future. Never before had they indicated to the market that they would maintain a target Rate for a specific period of time.

In September, the Fed once again took action to keep interest rates low, unveiling “Operation Twist.” The Fed said it would sell shorter-term Treasuries from its own portfolio and use proceeds from the sales to buy long-term Treasuries – a move designed to lower long-term interest rates.

The net result of these actions, illustrated in the chart below, was that US Treasury rates actually declined over the course of year. Short end Treasury rates remained low because they are primarily driven by the Federal Funds rate, which remained at 0%. Longer maturity Treasuries actually moved lower in yield, driven by the Fed actions as well as by increased investor concern over European sovereign default risk.

At the start of 2011, there was also a great deal of fear about the health of the US municipal bond market. Numerous states were facing budget deficits and cities were grappling with everything from falling tax revenue to rising pension costs. Wall Street analysts meanwhile were predicting that municipal defaults would be large in both size and quantity, with some fringe analysts even predicting that defaults could total hundreds of billions of dollars.

Well, it’s nearly one year later. While a few high-profile defaults and bankruptcies were announced — like the Jefferson County bankruptcy — wide-scale defaults never materialized.

According to S&P, municipal defaults in 2011 are down 69% compared to the same period in 2010. Year-to-date monetary defaults in the S&P Municipal Index total roughly $750 million, representing less than 0.5% of the index. This compares with 2010 defaults of $2.4 billion.

Despite the dire predictions, most municipalities have a number of tools at their disposal – like raising taxes, cutting spending or laying off government workers — to help them make timely payments on their debt and to avoid defaults.

What’s the lesson learned from 2011? Diversification and liquidity are key, especially in volatile markets. All markets rise and fall, and the fixed income markets are no exception. Having a diversified portfolio can help to insulate your holdings, while being in liquid investment vehicles allow you to make timely, tactical investment decisions based on changing market environments.

Footnotes: 1 Source: Investment Company Institute: Estimated Long-Term Mutual Fund Flows report data as of 11/22/2011

Diversification may not protect against market risk. Liquidity of investments is not guaranteed.

Bonds and bond funds will decrease in value as interest rates rise.

Written By Matthew Tucker From The iShares Blog

Matthew Tucker has spent the past 16 years focused on fixed income analytics, portfolio management and strategy. As managing director of U.S. fixed income strategy at BlackRock, Inc., and a member of the Fixed Income Portfolio Management team, Mr. Tucker leads both product strategy for ETFs and North America and Latin America iShares strategies, as well as product delivery and client sales. He previously worked with Barclays Global Investors before it merged with BlackRock, and he led the U.S. Fixed Income Investment Solutions team responsible for overseeing product strategy for active, index, enhanced index, iShares and long/short products. Mr. Tucker was also a portfolio manager and a trader in fixed income focused on U.S. government securities.

He began his career at Barra, where he supported clients using the company’s fixed income analytics. Mr. Tucker holds a bachelor of business administration degree from the University of California, Berkeley, and is a Chartered Financial Analyst charterholder.

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