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

The broad bond market, as measured by the Barclays Capital Aggregate Bond Index (“Aggregate Bond Index”), posted a quarterly return of 3.74%, its best quarterly return of the year. Year-to-date, the Aggregate Bond Index has returned 5.72%. The third quarter experienced a general decline in interest rates across the U.S. Treasury yield curve, despite the opposing forces of strong equity market rallies and indications of economic growth and financial market stability. As has been the case for the majority of the year, many bond sectors materially benefited from the further contraction in risk premium (spread contraction) as many investors continued to increase their appetite for riskier assets and take advantage of the historically attractive valuations of non-U.S. Treasury fixed-income assets. All bond sectors posted positive returns during the quarter; however, the return dispersion across and within sectors varied greatly. In general, investors were well-compensated for taking risks as riskier assets generally outpaced their more conservative counterparts. During the quarter, exposure to bonds provided investors both return and diversification benefits.

The Federal Open Market Committee (“FOMC”) met on several occasions during the quarter, most recently on September 23. The FOMC maintained its target range for the federal funds rate at 0% to 0.25% and stated that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” It was also announced that certain programs related to the purchase of mortgage-backed securities and the Term Asset-backed Securities Loan Facility (“TALF”) would be extended, which helped provide market stability. U.S. Treasury yields were less volatile compared to the first half of 2009 and fell modestly across all maturities, more so on the longer end of the curve. Given the inverse relationship between bond yields and prices, the downward movement in yields was positive for U.S. Treasury prices, helping to offset some of the sector’s losses from earlier in the year. The yield on the 10-year U.S. Treasury ended the third quarter at 3.31%, falling 23 basis points from the previous quarter’s close.

Thus far, the 2009 bond market has been greatly characterized by the material amount of spread compression that has occurred. With higher demand by investors and stabilizing economic fundamentals, this phenomenon continued during the third quarter, serving as a tail-wind and rising tide for many fixed-income sectors. The investment-grade corporate bond sector posted a quarterly return of 8.12%, led by long-maturity financial bonds which were up 16.88%. These bonds were up strong as fears over a sustained, recession waivered. Also notable were corporate bonds outside of the financial sector as both long-term industrials and long-term utility bonds posted quarterly returns north of 11.00%. Regarding quality, lower quality corporate bonds (BBB) materially outpaced higher quality peers. Agency mortgage-backed securities (MBS) also outpaced U.S. Treasuries during the period as the segment posted a quarterly return of 2.31%. The sector benefitted from the Federal Reserve’s mortgage purchase program which compressed mortgage premiums to lower levels. Non-agency mortgage securities also rallied, benefitting from improved liquidity in the market. Asset-backed securities (“ABS”) were one of the top performing sectors at 6.30%, with the top performing segments being home equity loans and autos. The ABS sector continued to benefit from the government’s Term Asset-Backed Securities Loan Facility (“TALF”). Money market instruments tended to be the worst performing segment of the market as short-term rates hovered near 0%.

Certain extended bond sectors posted noteworthy returns. The top performing segment of the market was high yield (below investment grade) corporate bonds. With improving economic conditions/fundamentals and access to needed capital, the financial position of these companies elevated and prices have rallied from historical lows experienced in late 2008. As a sector, high yield bonds posted a quarterly return of 14.22%, rivaling the returns of the domestic equity market. Lower quality bonds led the high yield rally for the quarter. Emerging market debt performed strongly during the third quarter, posting a quarterly return of 10.24%. These securities benefited from favorable stimulus programs in an effort to offset a sluggish global economy. Investors' risk appetite for the sector was also beneficial.

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