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

A broad overtone of renewed optimism seemed to spread throughout the fixed-income markets as investors willingly abandoned safe haven assets to reintroduce risk into their portfolios. Underpinning investor outlooks were “green shoots” (improving economic data), increased credit market stability (partly due to government intervention), improved liquidity and traction in the equity markets. These factors led many to believe the worst of the economic crisis may be over allowing them to focus on the future and underlying fundamentals in lieu of depression scenarios.

Investors’ cash flows were directed toward spread (non-U.S. Treasury) assets to take advantage of historically attractive valuations. The quarter was characterized by a strong performance recovery in non-U.S. Treasury sectors, while Treasury performance lagged in response to rising yields. The broad U.S. bond market, as measured by the Barclays Capital Aggregate Bond Index (“Aggregate Index”), posted a quarterly return of 1.78%. Within the index, returns differed across different sectors, industries and maturities.

The U.S. Treasury yield curve became steeper during the quarter as short-term yields remained relatively stable while yields of mid- to long-term maturities increased. The steeper yield curve reflected a variety of factors, including increased risk appetite, the significant level of Treasury debt issuance to pay for the budget deficit, and the possibility of future inflation once the economy hits high gear. Given the inverse relationship between bond prices and yields, the U.S. Treasury sector was one of the worst performing segments of the bond market, posting a quarterly return of (3.02%). Long-maturity Treasuries, generating a quarterly return of (6.67%), dragged down the sector’s performance as these bonds were more price sensitive to rising rates. The quarter ended with the 10-year note yield at 3.53% (up 87 basis points) and the 30-year bond at 4.33% (up 80 basis points).

Spread sectors rallied as all non-Treasury sectors of the Aggregate Index outperformed U.S. Treasuries during the quarter. The investment-grade corporate bond sector posted a quarterly return of 10.45%, led by long-maturity financials, which were up 22.76%. Corporate bonds outside the financial sector were also robust, producing returns in excess of 10%. Asset-backed securities (“ABS”) were one of the better performing sectors at 7.64%, and top-performing segments were credit cards and autos. The ABS sector continued to benefit from the government’s Term Asset-Backed Securities Loan Facility (“TALF”) program. Mortgages, one of the largest bond sectors, outpaced Treasuries but lagged other spread sectors amidst the improving credit markets. Mortgages posted a quarterly return of 0.70%.

The higher risk-extended bond sectors benefited from investors’ strong appetites for risk and rallies in these sectors posted meaningful absolute returns. High yield bonds (defined as below investment-grade corporate bonds) posted a quarterly return of 22.80%, outpacing investment-grade counterparts and the broad equity market. Generally, the lower the quality of the bond, the higher the return as evidenced by triple C-rated bonds leading the high yield market. Emerging market debt was another top-performing extended sector, posting a quarterly return of 10.71%.

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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.