Fixed Income Quarterly Review
Fixed Income Quarterly Review, 9 / 2009
Chart 1: The Treasury Yield Curve
The Treasury yield curve came down in yield across all maturities during the second quarter as the bond market adjusted to lower expectations for growth and inflation. Longer maturity yields fell more than shorter maturity yields.
The 2-year Treasury yield fell 16 basis points, beginning the quarter yielding 1.11% and ending at 0.95%. The 10-year Treasury yield fell 22 basis points, starting the quarter at 3.53% and ending at 3.31%. The 30-year Treasury yield fell 28 basis points, starting the quarter at 4.33% and ending at 4.05%.
Chart 2: The Shape of the Yield Curve
The yield difference between 10-year U.S. Treasury rates and 2-year U.S. Treasury rates decreased slightly during the third quarter from 242 basis points at the end of June to 232 basis points at the end of September. This decrease came about as longer dated yields fell further than shorter dated yields.
The current steep yield curve incorporates rising inflation and growth expectations as well as the Federal Reserve's efforts to keep short-term interest rates low for an extended period. Very steep yield curves, as well as negative yield curves, tend to moderate toward more normal levels. In the case of the 10-year and 2-year Treasury yields, the difference over the past three decades has been around 62 basis points.
Chart 3: Corporate Bond Spreads
Corporate bond risk, as measured by the yield spread of the Merrill Lynch Corporate Master index continued to improve during the third quarter. Beginning the quarter 331 basis points above the Treasury market, corporate yield spreads tightened to finish the quarter 235 basis points above Treasuries.
Much of the tightening in the corporate bond sector can be attributed to a sense in the market place that the worst of the recession is behind us. Add to this sentiment low interest rates in government debt instruments and high-grade corporate bonds become a very appealing sector to add yield.
Chart 4: Intermediate Term Bond Market Performance By Sector
The performance across investment-grade bond sectors was dominated by corporate bonds, which widely outperformed all other sectors for the quarter and trailing 12-months. Mortgage-backed securities followed at a wide distance with the second best performance for the quarter and trailing 12 month periods. Treasuries only outperformed agency debt by a small margin during the quarter and were the worst performing sector over the past 12-months.
Chart 5: Assets On The Federal Reserve Balance Sheet
A large part of the easing of stress in the financial markets can be attributed to the Federal Reserve. By leveraging their balance sheet and becoming the lender of last resort, an important role of central banks during crisis, fresh money can be put into the economy to support trade and investment.
During this downturn, extraordinary monetary effort was exerted. The assets on the Federal Reserve balance sheet pre-crisis averaged between 850 and 900 billion dollars. Since the fourth quarter of 2008 the balance sheet of the Fed has averaged roughly between 2.00 and 2.25 trillion dollars. An effective exit strategy will require the Fed to reduce their balance sheet.
Chart 6: 3 Month LIBOR Yield - 3 Month Treasury Bill Yield
One of the first casualties of the financial crisis that swept across the markets during the third quarter of 2008 was the cost of short-term financing. The Lehman Brothers failure on September 15, 2008, begat a crisis in the money market funds and consequently all short-term financing not explicitly backed by the U.S. Government became very expensive.
The yield between 3-month LIBOR and 3-month T-Bills reached a peak of 319 basis points at the end of September 2008. Efforts by the Federal Reserve and U.S. Treasury have helped greatly to reduce the financing costs for corporations. At the end of the third quarter, the 3-month LIBOR/T-Bill spread stood at just 17 basis points. Dating back to December 1984, the median spread has been 45 basis points making the current spread historically low. This should ease corporate efforts to restore profitability during the current global recession.
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