By Matt L. Peden, CFA, Vice President, Investment Officer 

As 2007 came to a close, one noticed how dramatically different the year ended compared to its beginning. The year set in motion with discussions about economic growth and its sustainability while ending with anxiety and concerns over a soft economic landing or even the dreaded “R” word — recession. The spillover effect of a declining housing market and sub-prime losses heightened concerns over a slowing economy. The last six months of 2007 seemed to define the fixed income market for the year — one that experienced a return in volatility, a re-pricing of risk across capital markets, an increase in credit issues and an easing monetary policy.

Despite widening spreads in non-Treasury sectors, the overall downward pressure on yields during the quarter proved rather bullish for bond investors given the inverse relationship between bond yields and bond prices. The broad fixed income market, as represented by the Lehman Brothers Aggregate Bond Index, generated a quarterly return of 3.00%, elevating the index’s annual performance to 6.97% (its highest calendar year return since 2002). Within this tumultuous environment, bonds provided investors both diversification and return benefits, as they outperformed their broad equity market counterparts.

Entering into the fourth quarter, market expectations were for the Federal Reserve (“Fed”) to cut rates further in an effort to provide liquidity and inject stimulus into a slowing U.S. economy. The Fed delivered by cutting rates by 25 basis points on two separate occasions, bringing the Fed Funds target rate to 4.25% at year-end. Fighting opposing forces, the Fed struggled to delicately balance its easing monetary policy amidst inflationary pressures (rising energy and commodity prices). At year-end, the futures market anticipated further rate cuts in 2008. U.S. Treasury yields fell materially across the yield curve, most notably on the short-end, causing the yield curve to further steepen. The yield of the 2-year U.S. Treasury fell by 94 basis points to end the year at 3.05%, while the yield on the 10-year U.S. Treasury dropped 56 basis points to 4.02%. The yield on the 30-year Treasury bond fell 38 basis points to close the year at 4.45%.

Given the increase in volatility and uncertainty, there was return dispersion among the various bond sectors during the quarter. The U.S. Treasury sector, benefiting from demand associated with a “flight-to-quality,” was the quarter’s best performer. Long-term government securities, as measured by the Lehman Brothers Government Long-Term Bond Index, posted a quarterly return of 5.59%. Other sectors such as corporates, mortgages and asset-backed securities lagged in comparison (on a duration weighted basis). High yield bonds posted negative quarterly returns, but emerging market debt continued to perform well, both on a U.S. dollar and local pay basis. The J.P. Morgan EMBI Plus Index, a proxy for U.S. dollar pay emerging market bonds, posted a quarterly return of 2.68%.

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All indices are unmanaged and not available for direct investment. Index performance assumes no taxes, transaction costs, fees or expenses. This update is prepared for general information only and it is not to be reproduced.

GuideStone Funds shares are distributed by PFPC Distributors, Inc., a registered broker-dealer and underwriter of the funds, 760 Moore Road, King of Prussia, PA 19406. GuideStone Capital Management, a controlled affiliate of GuideStone Financial Resources, serves as the investment adviser to GuideStone Funds.