Fixed Income Quarterly Review
Fixed Income Quarterly Review, 12 / 2007
Chart 1: The Treasury Yield Curve
The credit related issues that arose during the third quarter continued into the fourth quarter. The response saw U.S. Treasury yields fall across all maturities. The 2-year Treasury yield fell 94 basis points, beginning the quarter yielding 3.98% and ending at 3.04%. The 10-year Treasury yield fell 56 basis points, starting the quarter at 4.58% and ending at 4.02%. The 30-year Treasury yield fell 38 basis points, starting the quarter at 4.83% and ending at 4.45%.
Chart 2: The Shape of the Yield Curve
The shape of the yield curve, measured by the yield spread between the 10-year and 2-year Treasury yields increased during the quarter. The Treasury curve began the quarter with 60 basis points between 10-year and 2-year yields and finished with 97.
In the past 30 years, the median spread between 10-year and 2-year Treasury yields has been 70 basis points. The current reading of 97 basis points shows the yield curve to be slightly steep by historic standards.
Chart 3: Corporate Bond Spreads
The yield spread on the Merrill Lynch Corporate Master index rose 54 basis point, beginning the quarter 149 basis points over Treasuries and ending 203 basis points over. Over the past 10 years, the yield spread on the Merrill Lynch Corporate Master index has ranged from a low of 54 basis points in September 1997 to a high of 247 basis points in October 2002. The average spread over the 10 year period has been 122 basis points making the current level of corporate bond spreads wide by historic standards.
Chart 4: Intermediate Term Bond Market Performance By Sector
A fourth quarter flight-to-quality put a tailwind behind bond prices, moving them up and providing for positive absolute returns.
U.S. Treasury notes were the best performers for the fourth quarter and the calendar year. U.S. Agency notes were the second best performers for the year but trailed mortgage backed securities for the quarter. The credit crisis of the second half of 2007 impaired the performance of corporate bonds and they trailed all other sectors for the quarter and year.
Chart 5: Housing Starts
Much of the stress in the credit markets involve securities backed by activity in the housing market. With the gradual rise in interest rates from 2004 to 2006, the historically hyper-active pace of home building peaked and began to fall in early 2006.
The U.S. Department of Commerce measure of housing starts, released monthly, shows a persistent decline from a peak annualized pace of 2.3 million units to an expected December 2007 pace of 1.1 million units. While this is a material slowdown and below the long-term average of 1.5 million units, it appears necessary to correct a very large inventory of homes for sale.
Chart 6: Three Month LIBOR Spread*
The credit crisis, which began in the third-quarter, carried on into the fourth quarter.
The London Interbank Offered Rate (LIBOR), is an indication of the degree to which the short-term credit markets were concerned. This is the rate that banks lend to each other. The 3-month LIBOR rates widened to Treasury bills during the fourth quarter, signaling to the Federal Reserve a need for additional action to calm the concerns in short-term debt markets.
LIBOR began the quarter yielding 5.22% and ended the quarter at 4.70%, a drop of 52 basis points. T-Bills began the quarter yielding 3.80% and ended at 3.24%, a larger fall of 56 basis points. Bringing the LIBOR spread down is a key factor in calming the jittery credit markets.
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