Jim Kochan

Bonds: The year in review

AdvantageVoice® Blog—1-7-13
James Kochan, Chief Fixed-Income Strategist

Credit was the key to performance in the bond markets in 2012. In a reversal from 2011 when Treasuries were the best performing taxable sector, the corporate markets significantly outperformed in 2012. The banking sector, with a total return of 15%, provided a big boost to the investment grade corporate market. Among quality grades, returns from the BBB segment of the IG market were almost double those from the AA credits for the full year and for the fourth quarter. In December, the AA credits returned -0.25% while the BBB credits returned 0.20%.

In the high yield market, the CCC and weaker category produced a total return of 19.7% for the year, versus returns of 15.0% and 14.4% for the B and BB segments, respectively. In the fourth quarter, however, when the high yield rally slowed somewhat, the BB- and B-rated credits performed almost as well as the weakest credits.

The municipal market corrected somewhat in December, but even with that setback, it had a strong year. In December, the stronger credits and shorter maturities performed best, but the opposite was true for the quarter and the year. With yield curves quite steep during all of 2012 and with yields declining most of the year, maturities of 10-years and longer returned 9.7% versus returns of 5.3% for the 7-12 year index and only 1.0% for the 1-3 year index. Very wide quality spreads were another key feature of the market all year. As a result, a portfolio of A/BBB credits would have outperformed a portfolio of AAA/AA credits by almost 400 basis points in 2012.

Investing for safety proved to be very expensive again in 2012. Three month Treasury bills returned 0.12% last year. The entire Treasury complex underperformed, partly because demand from overseas weakened significantly during the second half. Even the mortgage market substantially underperformed the credit sectors, despite the Fed’s monthly purchases of $40 billion of mortgage-backed securities. With investors starved for yield, Treasuries and those sectors with narrow spreads to Treasuries were ignored in favor of the corporate and international markets.

Bond market total returns (%)

Market 2010 2011 2012 Q4 2012 December
Broad market index 6.80 7.80 4.53 0.27 -0.16

Corporate 9.52 7.51 10.37 1.21 -0.02

Treasuries 5.88 9.79 2.16 -0.10 -0.49

Agencies 4.61 5.27 2.44 0.22 -0.16

Mortgages 5.67 6.14 2.59 -0.27 0.14

Asset-backed 5.02 1.43 3.03 0.53 0.13

High-yield 15.24 4.50 15.58 3.18 1.59

Municipal 2.25 11.19 7.26 0.51 -1.95

2-year Treasury 2.28 1.45 0.28 0.07 0.03

5-year Treasury 6.76 9.20 2.27 0.02 -0.30

10-year Treasury 7.90 17.15 4.18 -0.21 -1.08

30-year Treasury 8.65 35.50 2.48 -1.17 -2.50

Source: Bloomberg
Past performance is no guarantee of future results.

Looking ahead

Every market observer, analyst, or commentator is expected to make predictions at the beginning of a New Year. It is a dangerous and, at times, foolhardy tradition. After a year of exceptional performance by the credit sectors, many of these forecasters are warning that those markets could be hurt badly if rates were to rise or if the large sums that have flowed into mutual funds were to reverse. Several widely quoted observers and participants are warning of a major correction at some point in the future. Over the next twelve months, however, sharply higher interest rates do not appear likely. The Federal Open Market Committee has stated quite clearly that they have no intention of changing policy as long as the unemployment rate is above 6.5%, and nobody expects that threshold to be breached this year. While bond yields can rise even as the fed funds rate remains near zero, any such increases tend to be limited—not the onset of a steep cyclical uptrend.

The second concern—that investors could flee bond investments at the first sign of negative returns—is probably a more legitimate risk. But what is their alternative? Presumably, investors are in the bond market because they need income, and cash equivalents still offer no income. Equities have become very attractive versus bonds, but even another year of strong returns from that market has not sparked inflows to those mutual funds. It is difficult to envision a scenario that would result in a large-scale shift of funds out of fixed income into equities. If income remains a key objective of investors, the corporate and municipal sectors would be expected to continue to perform well, albeit not as strongly as in 2012.

The views expressed are as of 1-7-13 and are those of Chief Fixed-Income Strategist James Kochan and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.


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