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

An allocation to bonds provided investors both return and diversification benefits relative to equities during the quarter. The broad bond market, as measured by the Barclays Capital Aggregate Bond Index (“Aggregate Bond Index”), posted a quarterly return of 3.49%, as all major sectors posted positive returns during the period. Bonds outpaced their equity counterparts (as measured by the S&P 500® Index) by nearly 15 percentage points during the quarter (3.49% compared to -11.43%). Over the previous 12 months, the Aggregate Bond Index has generated a return of 9.50%, outpacing its long-term historical average.

The second quarter was marked by investors’ sentiment shifting negative, becoming more risk averse with an intense focus on uncertain implications related to unfavorable macroeconomic factors including: the European financial and debt crisis, prospects for slower global economic growth, renewed fears of deflation, an elevated fiscal deficit and high levels of unemployment. The culmination of these factors renewed investors’ fears of a “double dip” recession which led to volatility and a strong rally in bond prices, most notably within the U.S. Treasury sector. While the U.S. Treasury sector outpaced other bond sectors during the quarter, other major sectors posted positive returns as risk premiums (spreads relative to U.S. Treasuries) remained relatively unchanged or widened modestly.

The Federal Reserve Bank (“Fed”), as has been the case for some time, maintained the targeted federal funds rate at 0%-0.25% during the quarter. The Fed appears to be firmly on hold as it stated that “economic conditions warrant exceptionally low levels of the federal funds rate for an extended period." The Fed was left with no choice but to leave rates at historical lows as deflation had resurfaced as a primary threat. Short-term rates, which are often tethered to the federal funds rate, remained at historically low levels. Such levels continued to place severe pressure on money market funds’ ability to generate positive absolute returns on behalf of investors.

The U.S. Treasury yield curve experienced a sharp decline in yields across all maturities during the second quarter due to strong global demand for the “safe haven” securities. Such high demand helped the U.S. Treasury manage the process of financing the U.S. burgeoning debt level. The yield on the 10-year U.S. Treasury fell below the 3.00% level for the first time since early 2009, reflecting investors’ “flight-to-quality” and “liquidity” flows, lower inflation expectations and fears of another recession. The yield decline was obviously bullish for fixed-income securities. Leading the way were long-term U.S. Treasuries, which posted a quarterly return approximating 15%. U.S. Treasuries, as a sector, generated a quarterly return of 4.68%. U.S. Treasury Inflation Linked Securities (“TIPS”) produced a quarterly return of 3.82%, underperforming their nominal counterparts as market-implied, breakeven inflation rates decreased during the period.

Bond returns outside of U.S. Treasuries varied. Investment-grade (rated BBB category or higher) corporate bonds generated a quarterly return of 3.42%. Within the corporate bond sector, utility bonds performed best while obligations of financials generally lagged over fears of sovereign credit exposure and the financial reform in the U.S. At somewhat high spread levels, many market pundits perceive corporate bonds as attractively valued for longer-term investors. Another large bond sector is the mortgage-backed sector, which generated a return of 2.87% for the quarter. Agency mortgage bonds were positively impacted by a favorable supply/demand environment as such securities remained attractive to investors seeking yield. Generally speaking, longer-dated bonds outpaced their shorter-term counterparts while quality orientation was not a material return factor within the investment grade credit quality segments.

High yield bonds (defined as below investment grade corporate bonds), which at times are highly correlated to equity markets, generated a flat return for the quarter; thereby, underperforming investment grade corporate bonds but materially outpacing equities. The cautious sentiment of investors hurt the high yield sector during the quarter; still, many believe fundamentals and valuations for such securities remain attractive. Emerging market debt, supported by strong fundamentals, posted a return of 1.43%.

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.

S&P 500® is a trademark of The McGraw-Hill Companies and has been licensed for use by GuideStone Funds. The Equity Index Fund is not sponsored, endorsed, sold or promoted by Standard & Poor’s and Standard & Poor’s makes no representation regarding the advisability of purchasing the Equity Index Fund.

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 BNY Mellon 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.