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

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Despite historically low levels of interest rates, an allocation to bonds during the third quarter continued to reward investors with positive returns and diversification benefits versus the volatile equity markets. The broad bond market, as measured by the Barclays Capital Aggregate Bond Index (“Aggregate Bond Index”), posted a quarterly return of 2.48%, as all major sectors posted positive returns during the period. The third quarter was marked by continued fears of a “double dip” recession that eventually gave way to renewed optimism by quarter-end, as investors became less risk averse on the prospects of further quantitative easing by the Federal Reserve (“Fed”). Investors’ appetite for risk led to strong performance within the equity markets and the outperformance of certain bond sectors, such as high yield and corporate bonds, which trade at a spread over U.S. Treasury bonds. Over the previous twelve months, the Aggregate Bond Index has generated a return of 8.16%.

U.S. interest rates continued to fall during the quarter as economic growth remained anemic and inflation stayed below the Fed’s long-run preference range of 2%, which elevated the central bank’s concerns related to deflation. During the quarter, the Fed maintained the federal funds target rate within the range of 0% - 0.25%, as they could not lower interest rates further to invoke economic stimulus. However, as the quarter began to close, the market began anticipating that the Fed, through unconventional means, would further expand its balance sheet through an additional round of quantitative easing (commonly referred to within the markets as “QE2”). Under QE2, it was anticipated that the Fed, beginning in November, will begin purchasing and expanding its ownership of longer-term U.S. Treasury securities. This news, coupled with low inflationary fears, led to lower mid- and longer-term interest rates and a flattening of the U.S. Treasury yield curve. The Fed believes that low short-term rates and QE2 will help the economy in several ways: (1) lower interest rates will provide incentive for companies to stop stockpiling cash and deploy it towards higher returning capital projects which could lead to job growth and consumer spending; and (2) it provides evidence towards the Fed’s fight against deflation, reducing the fears and anxiety in the marketplace of such an outcome. Reducing such fears could lead to optimism and an improved sentiment and outlook for the economy.

The U.S. Treasury yield curve experienced an interest rate decline across all maturities, most notably in the five to ten year maturities. Declining yields, coupled with a continuation of credit spread contraction, provided a tail-wind for the bond market leading to positive returns. As a sector, U.S. Treasuries generated a quarterly return of 2.73%. Leading the way within the sector were long-term U.S. Treasuries. The 30-year U.S. Treasury Bond generated a quarterly return of 4.71%, bringing its year-to-date return to 20.62%. U.S. Treasury Linked Securities (“TIPs”) produced a quarterly return of 2.48%, benefitting from falling real yields, but trailed nominal bonds as breakeven inflation levels declined during the period.

Given investors were seeking incremental higher yields (in the low return environment) and more willing to take on risk, it is not surprising that several non-U.S. Treasury sectors were the top performers during the period. Investment-grade corporate bonds (credit ratings of BBB category or higher) was the top performing sector within the Aggregate Bond Index, generating a quarterly return of 4.71% with long-term corporate bonds returning 6.17%. The corporate bond sector benefitted from both fundamental and technical factors. Fundamentally, corporate balance sheets remained strong, plush with high cash balances and declining leverage, while the technical environment was positive as investor demand remained elevated as they sought higher yields in lieu of low yielding U.S. Treasury securities. The mortgage-backed securities (“MBS”) sector was the laggard within the Aggregate Bond Index, posting a return of 0.63% as interest income was somewhat offset by spread widening (declining prices).

High yield bonds (defined as below investment grade corporate bonds), which at times are positively correlated to the equity markets, posted a robust return of 6.75%. Although the sector underperformed U.S. equities, it was one of the best performing areas within the bond market. The high yield segment benefitted from strong technical demand as investors sought the attractive high coupon while the fundamental health of such issuers has been improving. High yield issuers have benefited from refinancing activity which has led to lower borrowing costs and higher debt service coverage ratios.

Emerging market debt (debt issued by emerging market countries) was the best performing area of the bond market, producing a quarterly return of 8.90%. Prospects for strong economic growth and healthy fiscal deficits, coupled with strong investor demand, have led to material spread tightening (relative to U.S. Treasuries) and price appreciation.

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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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.