Investor uncertainty dominated bond markets in late 2011

Investor uncertainty dominated bond markets in late 2011

Uncertainty remained high in the fourth quarter of 2011 as the large macroeconomic challenges that dominated headlines throughout the year continued to weigh on investor confidence. Treasury rates in the United States declined slightly amid solid demand, while discussions over reducing the size of the federal deficit continued to take center stage heading into the 2012 election year.

Outside the United States, little progress appeared to be made in the European sovereign debt situation despite ongoing negotiations. Given how deep-seated the fiscal problems are in southern Europe, we do not believe we are likely to see Italy borrow at German rates anytime in the foreseeable future. It is unclear, therefore, what the incentive is for countries like Greece and Italy to remain committed to a single European currency, which limits their policy options for dealing with their debt loads.

In non-Treasury bond markets, mortgage-backed securities in particular struggled to reverse course after their significant sell-off in the third quarter. However, one bright spot was found within corporate debt, particularly high-yield bonds, which rallied to close out the year after a difficult third quarter.

We continued to have limited exposure to interest-rate risk in our portfolios during the quarter, which detracted somewhat from relative returns. That said, we also believe that with interest rates in a number of markets near historic lows, the potential rewards from a long-duration stance are minimal. Economic data in the United States have been surprisingly strong in recent months and although the U.S. Federal Reserve has pegged the short-term rates at near-zero levels, we believe the possibility of higher rates, especially at the longer end of the yield curve, is substantial.

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