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Bond Market Perspectives

The yield curve, a graphical representation of yields across the maturity spectrum of the bond market, has long received attention as a relatively good leading economic indicator. A flat or inverted yield curve has often predicted an economic slowdown or recession, while a steep yield curve foreshadows economic growth.

However, the shape of the yield curve can impact total returns for bond investors and help determine which maturity segments-short, intermediate, or long-term-of the bond market offer the most attractive potential reward for a given amount of interest rate risk. The year-to-date rise in high-quality bond yields coupled with the current shape of the yield curve may offer investors an opportunity in high-quality bonds.

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The yield differential between 2- and 10-year Treasury yields is one of the most common measures of whether the yield curve is "steep" or "flat". The greater the yield differential between 2- and 10-year Treasury yields the "steeper" the yield curve, and conversely, the narrower the yield differential, the "flatter" the yield curve is considered. Currently, the yield curve is moderately steep based upon the yield differential between 2- and 10-year Treasury yields but well off an historically steep yield curve in recent years [Figure 1].

Federal Reserve (Fed) policy has greatly influenced the yield curve since late 2010 when the Fed extended the maturity of it's bond purchases. Part of the Fed's unconventional policy measures included putting a date around the timing of the first interest hike. In August 2011, the Fed committed to refrain from raising rates until mid-2013, then shifted to late 2014, and subsequently modified to mid-2015 before moving to it's rough target of 6.5% unemployment (which also equates to roughly mid-2015 according to market expectations).

In mid-2011, the yield curve began to steepen notably at one year but that inflection point has been pushed out to three years now due to Fed policy. Although the yield differential between short and intermediate Treasuries is less today, the 3- to 10-year maturity segment remains the steepest portion of the yield curve [Figure 2].

The Fed's commitment to refrain from raising interest rates means there is much less interest rate risk for short-term and some intermediate-term maturity bonds compared to history. The year-to-date changes in Treasury yields reflect this phenomenon [Figure 3]. Treasury yields are higher year-to-date through, March 18, 2013, but the change primarily occurred in long-intermediate to long-term bonds. Thanks to Fed policy, short-term 1- to 3-year yields are essentially unchanged and the rise in bond yields is reflected almost entirely in longer term issues. The change in the 5-year Treasury yield is less than one-third of the 10-year. Short-term yields are likely to remain anchored due to the Fed's commitment and may benefit intermediate maturities as well. Historically, short-term yields responded more to changes to the likelihood of Fed interest rate hikes while longer term bonds reacted more to changes in economic growth and inflation expectations. This remains the case, but especially so today, as Fed policy implies less interest rate risk and greater stability for short and short-intermediate bonds.

A potential opportunity may exist among high-quality intermediate bonds following year-to-date strength in lower-rated bonds, the rise in high-quality bond yields so far in 2013, and ongoing Fed policy. The primary benefit of a steep yield curve is the added compensation, in terms of yield, for every year an investor extends maturity. The steeper the yield curve, the greater the benefit to extend maturity.

However, a steep yield curve also offers defensive benefits. Over time, a bond will "roll down" the yield curve to a lower yielding maturity and this helps support bond prices. This concept is illustrated in Figure 4 for intermediate Treasuries. Over a one-year time horizon, if interest rates do not change, the total return of the 5-year Treasury, 1.7%, exceeds it's current yield to maturity of 0.8% as of March 18, 2013. On the surface, the total returns illustrated in an unchanged interest rate environment may not seem like much, but we believe they stand out in a low-yield world. Such a holding could provide diversification benefits should the economy weaken or demand for high-quality bonds return. A slight decline in interest rates of 0.25%, in the event of safe-haven buying, resulted in meaningfully positive returns. Of course, if interest rates rise by 0.5%, investors suffer a loss, but again this may be an acceptable risk to take in order to potentially offset high-yield bond weakness, for example, after the sector's strong start to 2013.

The 5-year Treasury yield has held in a very narrow range of 0.6% to 1.2% over the past 18 months thanks in large part to Fed policy. We view the prospects of a rise in interest rates of 0.5% for 5-year bonds as unlikely given the Fed's commitment to keep interest rates low. Therefore, high-quality intermediate bonds may provide a better opportunity for more conservative investors. While the 10-year Treasury also provides an attractive total return if interest rates remain unchanged, the potential loss if interest rates rise by 1.0%, on the high-end of our Bull Case forecast in our 2013 Outlook , is risk we prefer to avoid. The 10-year Treasury yield has fluctuated in a wider 1.4-2.4% range over the past year and holds greater interest rate risk compared to 4- to 7-year bonds.

The analysis above exemplifies the defensive benefit a steep yield curve provides. The roll down strategy is used by many bond portfolio managers, and roll down is a key reason why we continue to focus on intermediate maturity bonds.

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