The Fed Intervention
The US economy stalled as the residential housing market affected both consumer and business spending, and weakness in the labor and equity markets hurt final demand. The Federal Reserve Board intervened significantly in demonstrating their viewpoint that, "Liquid, well-functioning markets are essential for the promotion of economic growth." In our view, the Fed will continue to emphasize new policy tools and show a willingness to intervene to ensure financial market stability. Less pronounced interest rate cuts are likely going forward, however, in light of the already low Federal Funds rate, some dissention amongst Committee members, and heightened inflationary concerns. In the meantime, stimulative fiscal policy and other public policy initiatives, including actions taken by the US Congress and Office of Federal Housing Enterprise Oversight (OFHEO) to ease conditions in the real estate market, will likely add support to the US economy.
Tough Environment For Corporate Bonds
During the first quarter, the Fund underperformed its Lehman Brothers Aggregate Bond Index benchmark. An overweight stake in corporate bonds was the primary detractor from performance, as all spread products underperformed Treasuries. In conjunction with poor equity market performance (the S&P 500 Index declined 9.5%), corporate bonds were the worst performing fixed-income sector during the quarter, lagging the benchmark by more than four percentage points. The option adjusted spread within the credit market reached its widest month-end mark on record at 259 basis points. In this environment, higher-quality investment grade corporates outperformed, as AAA bonds outperformed AA, A and BBB securities by 122, 185, and 156 basis points, respectively, reflecting the overall flight to safety in the credit markets.
Mortgage-backed securities underperformed during the first quarter as well, as volatility remained high and valuations suffered from weakness in the residential housing market. US Treasuries posted their largest quarterly return since the third quarter of 2002, as investors sought added safety amid the credit crisis. In addition, yields on the short-end of the yield curve declined sharply in the dramatic move towards quality, as evident by the yields on three-month and two-year Treasury bonds declining 192 and 146 basis points, respectively.
Concerns Ease
While financial markets remain fragile, the Fed's actions have led to a meaningful improvement in the functioning of the credit markets as it has eased concerns about counterparty and systemic risk. Credit spreads have since narrowed, albeit from very wide levels, and bonds remain cheap from a historical context. Thanks to these interventions, the corporate bond market can now focus on the fundamental economic backdrop as liquidity concerns have subsided.
Taplin, Canida & Habacht (TCH)
Miami, FL