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

Oftentimes the start of a new year comes with a renewed feeling of hope and optimism as one crosses the psychological barrier of a year-end. Unfortunately, much of the anxiety and concerns of 2007 crashed through this barrier, carrying over and infiltrating the fixed-income markets and financial system during the first three months of 2008. The mottos for investors during the quarter were “flight-to-quality” and “preservation of capital” as the repricing of risk across the capital markets continued amid investors’ concerns over a slowing domestic economy, credit issues, deleveraging of risk and the lack of liquidity. The strong “flight-to-quality” theme, coupled with the Fed’s easing monetary policy, drove U.S. Treasury yields further downward across all segments of the yield curve, most notably on the short-end, causing the yield curve to further steepen. The yield on the two-year U.S. Treasury fell by 146 basis points to end the quarter at 1.58%, while the yield on the 10-year U.S. Treasury dropped 61 basis points to 3.40%. The yield on the 30-year U.S. Treasury fell by 16 basis points to close the quarter at 4.29%.

Riskier sectors of the fixed-income market did not fare well. However, the overall downward pressure on yields during the quarter proved somewhat 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 2.17%. The index’s positive return was largely supported by the strong performance of the U.S. Treasury sector. As evidence, the Lehman Brother’s Treasury Index posted a quarterly return of 4.43%. Within the turbulent environment, bonds provided investors downside protection, diversification and return benefits, as they materially outperformed most equity markets.

Further deteriorating economic conditions coupled with stress on the financial system prompted the Federal Reserve to be proactive and decisive in using both traditional and nontraditional methods of intervention. Utilizing a traditional lever to stimulate the economy, the Federal Reserve cut the Fed funds rate by 200 basis points, bringing it to 2.25% at quarter-end. The central bank also cut the discount lending rate by 225 basis points during the same period. To bring stability and support to the financial system, the Federal Reserve felt it was necessary to take several unconventional steps including: expanding certain liquidity facilities; allowing broker-dealer access to the discount window; and directly intervening in JPMorgan’s acquisition of Bear Stearns. At quarter-end, the bond market anticipated further cuts in the Fed funds rate during 2008. Overall, the market appeared to look favorably on the Federal Reserve for its efforts.

Given the “flight-to-quality” and lack of liquidity in the markets, a wide return dispersion existed among the different fixed-income sectors during the quarter. The U.S. Treasury sector was by far the best performing sector as anxious investors sought preservation of capital and liquidity in lieu of riskier assets. Treasury Inflation-Protected Securities (TIPS) outpaced like-duration nominal Treasury bonds, benefiting from a decline in real yields. Mortgages were one of the better performing non-U.S. Treasury sectors, although it was a tough environment for the sector with higher volatility and a large amount of forced sellers in the market (such as hedge-funds). Corporate bonds continued to struggle during the period amid concerns over a slowing economic environment and a lack of investor appetite for the “riskier” bonds. As a result, credit spreads on corporate bonds continued to elevate, reaching levels not seen since the last credit crisis of 2002–2003. As to be expected, high yield (below investment grade) corporate bonds underperformed their higher grade counterparts. Emerging market debt held up during the turbulent market, outpaced high yield bonds but materially lagged the “safe-haven” of U.S. Treasuries.

Given the significant outperformance of U.S. Treasuries, it was a difficult relative performance quarter for active bond managers, who typically underweight the lower yielding sector in favor of higher-yielding, non-U.S. Treasury sectors such as mortgages and corporates. With spreads at historically high levels, active management should be able to take advantage of higher current yields and spread compression when “normalcy” returns to the fixed-income markets.

You should carefully consider the investment objectives, risks, charges and expenses of GuideStone Funds before investing. For a copy of the prospectus with this and other information about the funds, please call 1-888-98-GUIDE (1-888-984-8433) or download a prospectus. You should read the prospectus carefully before investing.

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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.