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

The broad fixed income market, as represented by the Lehman Brothers Aggregate Bond Index, generated a quarterly return of 2.84%, bringing the index’s year-to-date performance to 3.85%. The third quarter will be remembered as a period of tremendous volatility and turbulence which led to the re-pricing of risk across many fixed income sectors. The stormy environment led to a material "flight-to-quality," driving U.S. Treasury yields downward across all maturities. Despite spread widening in non-U.S. Treasury sectors, the overall downward pressure on interest rates proved bullish for fixed income investors given the inverse relationship between bond prices and bond yields. At the eye of the tumultuous storm was the collapse in subprime mortgages. This collapse became increasingly problematic as it led to liquidity constraints in other areas of the market. This event, coupled with weakening data in certain areas of the economy, led to fears of a recession and resulted in a change in course in monetary policy for the major central banks around the world.

Entering the quarter, the Federal Reserve (“the Fed”) had maintained the Fed Funds target rate at 5.25% since mid 2006. Given the overshadowing effect of the subprime collapse and the credit crunch, the market was hoping for Fed action to mitigate concerns of a financial crisis and recessionary pressures. The Fed delivered above most expectations and cut the Fed Funds target rate (for the first time since the summer of 2003) by 0.50% to 4.75%. Furthermore, the Fed eased the discount rate by 0.50% on two separate occasions. Both the bond and equity markets rallied favorably in response to the Fed’s actions. U.S. Treasury yields fell materially across the yield curve, most notably on the short-end causing the curve to steepen. The yield on the 2-year U.S. Treasury fell by 0.87% to 3.98%, while the yield on the 10-year U.S. Treasury dropped 0.44% to 4.59%. The yield on the 30-year Treasury bond declined 0.29% to 4.84%.

During this highly volatile environment, investors sought refuge and their enthusiasm for high-quality U.S. Treasury securities heightened. The U.S. Treasury sector benefited from the demand associated with the "flight-to-quality" as the sector was the quarter’s top performer within the Lehman Brothers Aggregate Bond Index. Spread sectors, such as mortgages and corporates, generally underperformed their U.S. Treasury counterparts (on a duration-adjusted basis) given the spread widening of such securities, especially in July and August. By mid-September, the performance of non-U.S. Treasury sectors began to improve as investors had time to evaluate the market subsequent to the Fed’s rate cut. Non-U.S. dollar bonds, especially local pay emerging market debt, performed well in response to an overall weakening U.S. dollar amidst falling rates. Generally speaking, higher quality bonds outpaced lower-quality counterparts during the period.

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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.