1. Fixed Income Market Update
April 2010
Economic Picture:
The investor spotlight was redirected last month from an improving domestic landscape towards the myriad
of problems facing Greece and the European Union. Just months earlier, government authorities believed
the burgeoning problems in the EU had been successfully dealt with, and they were on the road to recovery.
However, this was not to be the case, as recent woes have cascaded and careened out of control. While
Greece's problems are the most grave, there are several other euro denominated countries that are also
experiencing major problems. The 'BRIC' countries (Brazil, Russia, India, and China) have been Wall Street
darlings for years. However, the inverse of that acronym has been dubbed the 'PIGS' (Portugal, Italy,
Greece, and Spain). Each of these countries were considered growth engines for the EU from the late 1990s
until the financial crisis started in 2007. Today, the EU has been badly shaken. This group, and in particular
Greece, have budget deficits that are akin to endless sinkholes. As a direct result of their monetary
problems, the previously strong euro has been turned into a whipping boy (the euro is trading at a 14-month
low vs. the dollar) and Greek interest rates now trade at high-yield levels. And to further agitate matters, in
late-April S&P downgraded Greece's debt to 'junk' status and reduced the credit ratings for Portugal and
Spain's debt as well. Fixed-income investors that purchased Hellenic debt prior to these recent
developments are now wincing in pain as reality sets in from tough austerity measures being imposed. Food
for thought, travel brochures that tout the enjoyments of the Greek Isles should consider adding the line:
investing in Greek bonds can be hazardous to you health.
On the home front, April’s economic data was positive. Virtually every sector of the economy showed signs
of improvement. As you would expect, manufacturing continued to lead the way. However, the all-important
consumer (70% of the economy) is spending again, and the downtrodden housing industry outperformed
expectations. March's industrial production rose for the ninth consecutive month, while capacity utilization
reached its highest reading since late 2008. Despite a renewed drop in consumer credit, March's retail sales
and personal spending have registered six straight gains. Retailers reported shoppers turned out in
surprising force in March, adding to a growing sense that the recovery could be more rapid than anticipated.
Also important, the Conference Board's Leading Economic Index (March) increased for a 12th consecutive
month and now stands at its highest level since records began in 1959. In comparison, the ISM Index of
Manufacturing (April) hit its highest reading since June 2004. Housing rebounded last month as the first-time
homebuyers tax credit neared expiration. Linked to that, new home sales and existing home sales (both
March) posted their first gains in four and five months respectively. Plus, March's housing starts reached its
highest level since November 2008. Even construction spending (March) participated, as it turned positive
for the first time in five months. Richard DeKaser, President of Woodley Park Research in Washington, said
"We are unambiguously seeing an improving trend in residential activity which counters the collapse over the
last three years". Jeffrey Detwiler, President and CEO of a private real-estate company in Virginia, said "The
meat and potatoes of the housing recovery is affordability. The tax credit is the gravy on top of that".
April's total vehicle sales increased almost 20% from March's levels, and the year-over-year gain was up
roughly 17%. More importantly, pickup sales have rebounded recently. This category is typically a harbinger
for the economy since small business owners make up nearly 75% of the buyers. Of note, General Motors
repaid a $6.7 billion U.S. government loan last month ahead of schedule. Plus, Chrysler, reported a 1st Qtr.
operating profit and boosted its cash reserves.
The long awaited release for 1st Qtr. GDP showed the U.S. economy expanded at a 3.2% annual rate as
households spent more freely. The increase in gross domestic product was in line with street estimates and
capped the biggest six-month gain since 2003. Consumer spending rose at a 3.6% pace last quarter, the
most since the first quarter of 2007. Troy Alstead, CFO of Starbucks Corp, said "We're benefiting from a
consumer who's feeling just a little better". Jeffrey Immelt, GE's CEO, said "The clouds are breaking and the
forecast ahead of us is promising". Early street estimates for 2nd Qtr. GDP range between 3.0% and 4.0%.
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2. Fed Activity:
The FOMC met in late-April. As was widely expected, they remained on hold. This marked the eleventh
consecutive meeting that they have kept the fed funds rate at the historic low range of zero to .25%. The text
following their meeting said economic activity has continued to strengthen and the labor market was
beginning to improve. Growth in household spending has picked up recently but remains constrained by
(1) high unemployment, (2) modest income growth, (3) lower housing wealth, and (4) tight credit. Business
spending on equipment and software had risen significantly; however, investment in nonresidential structures
is declining and employers remain reluctant to add to payrolls. Housing starts have edged up but remain at a
depressed level. While bank lending continues to contract, financial market conditions remain supportive of
economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee
anticipates a gradual return to higher levels of resource utilization in a context of price stability. Lastly, with
substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable,
inflation is likely to be subdued for some time. The FOMC will meet again on April 28th.
April's inflation figures remained market friendly. Core CPI was unchanged (the 5th consecutive month
below .2%), while Y-O-Y core rose 1.1%. That marked the 16th consecutive month that Y-O-Y core inflation
has been below the Fed's targeted 2.0% rate, and it was the lowest reading since January 2004. Headline
Y-O-Y inflation was reported at 2.3%. On the manufacturing side, April’s core PPI rose .1%, while the Y-O-Y
core number increased .9%. That was the seventh consecutive month below 2.0%. Of note, employment
expenses in the U.S. rose .6% in the first quarter. The rise in the ECI was slightly above the street's
estimate, but it marked the 14th straight quarter that the component has remained below 1.00%. The central
bank's preferred GDP price gauge, which is tied to consumer spending and strips out food and energy costs,
rose at a .6% annual pace in the 1st quarter. That was the lowest reading since records began in 1959 and
down from a 1.8% increase the prior quarter.
Commodity prices rose in April. The Reuters/Jefferies CRB Index rose 1.6%, while the Journal of Commerce
Industrial Commodity Price Index increased 6.2%. With last month's gains, the JOCI has almost doubled
from its 5-year low in December 2008. It is now trading at its highest level since August 2008 (prior to the
financial meltdown that began in September 2008). The price of West Texas intermediate crude rose
roughly 3% to close above $86. In intra-month trading, it topped $87 a barrel, its highest level since October
2008. Lastly, the price of gold jumped 6% last month, closing at $1,180 an ounce.
Treasuries:
The treasury market picked up where it left off in late March as interest rates continued their upward trend.
In fact, the 10-yr treasury traded for a brief while at 4.0% during the first week of the month, its highest level
since last October. Then Greece's financial problems flared back into view as doubts about a rescue plan
rattled the euro and sent the country's bonds tumbling. One Wall Street firm had a research piece titled:
Containing the Contagion Concerns. Despite plenty of evidence that the U.S. economy was rebounding,
traders and investors became enthralled over the growing possibility that the European situation could turn
ugly and domino into a full blown sovereign debt nightmare. Fears of the unknown drove news headlines,
thus resulting in another flight-to-quality trade into U.S. treasuries. Add in the fact that the market had
technically held at 4.0%, and the buying spree was underway. Additional factors that fueled last month's rally
included: (1) fraud charges levied by the SEC against Goldman Sachs, (2) the Fed reiterating that they
would remain on hold for an expended period of time, (3) concerns that China's recovery was faltering, and
(4) problems related to the massive oil spill in the Gulf of Mexico. Taken together, these fears resulted in a
powerful rally that caused yields to decline anywhere from 25 to 35 bps from their intra-month highs. At
month's end, the yield on the 2-yr was below 1.0% again, while the closely watched 10-yr fell to 3.65%. The
30-yr long bond ended the month 33 bps lower at 4.50%, but traded as high as 4.85%. The 2-yr vs. 30-yr
yield curve tightened an additional 15 bps in April, closing at +355 bps.
Given last month’s rally, the Barclays Treasury Index posted a gain of 1.05%. Year-to-date, the Treasury
Index is up 2.18%. Intermediate maturities gained .78% in April, while long treasuries rose 2.79%. In fact,
maturities in excess of 20-years gained an impressive 3.34%.
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3. The U.S. posted a budget deficit for a record 18th straight month in March. The deficit was reported at
<$65.4 billion>, which was in line with the street’s estimate. When compared to the year earlier number,
March’s deficit was 66% smaller. The year-over-year narrowing reflected a decline in outlays for the
Troubled Asset Relief program. We are now six months into fiscal 2010, and the year-to-date deficit totals
<$717.0 billion>. That's 8% less than last year’s same period. A deficit that is forecast to reach a record
$1.6 trillion this fiscal year illustrates the challenges facing President Obama and Congress as they struggle
to spur the recovery while keeping the budget gap manageable. Deterioration in the government's balance
sheet in coming years raises the risk of higher interest rates. David Wyss, chief economist at Standard &
Poor's in New York, said "We can't keep this up. We're getting more revenue, but we are still spending.
That's the problem. You've got to start paying your way". Of note, state and local tax collections rose above
year earlier levels in the 4th quarter for the first time in more than a year. However, the WSJ reported that
states will face budget gaps for at least the next two years, largely because federal aid is ending.
April’s treasury issuance (non-bill) remained historically high at $192 billion. Since November, the Treasury
has auctioned at least $190 billion (non-bill) per month. However, for the first time since the financial crisis
began, bond traders are starting to factor in a new trend: a sharp drop in the sale of new debt. Sales of
treasuries have surged to record levels in the past two years, as the budget deficit climbed sharply. But now
a recovering economy has fueled a sharp increase in taxation receipts, thus reducing the need for issuance.
Any reduction in treasury sales would help mitigate a rise in long-term interest rates and reduce worries
about the treasury market crowding out private debt. "Treasury supply reductions are coming sooner, rather
than later and they will be deeper than the market expects", said Richard Tang, head of fixed-income sales
at Royal Bank of Scotland Securities. Analysts at RBS expect a cut in treasury issuance of some $90 billion
by September, the end of the current fiscal year. The bank now forecasts a lower budget deficit of $1.3
trillion for the 2010 fiscal year, down $200 billion from last year. Plus, they expect further improvement in
fiscal year 2011's deficit, to $1.1 trillion. This would reduce treasury debt sales by more than $650 billion.
On the flip side, Morgan Stanley predicts the supply of treasuries will fall by $52 billion this fiscal year, and by
$589 billion in fiscal 2011. A bank representative said "While we are encouraged by this improvement, it's
hard to get too excited because it's like drowning in 75 feet of water instead of 100 feet of water".
Agencies:
U.S. agencies slightly outperformed treasuries last month as spreads tightened between 2 to 5 bps. The
Barclays Agency Index gained .61% in April vs. a decline of .36% in March. However, last month’s excess
return was only 2 bps vs. 12 bps the month before.
Last month’s issuance included a debt offering from each of the three issuers. In early-April, Federal Home
Loan Bank priced $3 billion of a 3-yr at +23.5 spread. A week later, Fannie Mae priced $4.0 billion of a 2-yr
at +25 spread. Freddie Mac rounded out the month by pricing an additional $1 billion add-on to March's 3-yr
issue at +12.5 bps. The original spread was +31.5 bps (the 19 bps spread discrepancy is attributed to the
yield difference between the two treasuries used for pricing and tightening that has already occurred). As
usual, all three issues were well received by market participants.
Corporates:
Spreads continued their non-stop vigil of tightening last month. The lone exceptions were banks and
brokerage paper as the Goldman news cast a big dose of uncertainty over the market. The factors behind
last month's push forward were the same as in previous months: (1) spreads for many industries remained
attractive to treasuries, albeit spreads are a heck of a lot tighter today than they were in November 2008, (2)
the economy continued to show further improvement, (3) rising stock prices indicate that Corporate America
is rebounding strongly, and (4) cash from low yielding m-money market funds continue to pour into this
market as investors search for viable alternatives. Looking ahead, we believe value remains in certain areas
of the corporate bond market. Obviously the higher quality industrial names have already experienced most
of the spread tightening that we expected to occur. A prime example: 5-yr PepsiCo debt (Aa3/A-) was
trading at roughly +50 bps vs. the 5-yr treasury in early 2007 (prior to sub-prime problems appearing daily as
front page headlines). Fast forward to October 2008 (the nadir of the financial crisis), and 5-yr PepsiCo debt
was being quoted anywhere from +300 to +400 bps vs. the 5-yr treasury. Today, 5-yr PepsiCo debt is
trading at +25 bps (same management, same products, same ratings). Given the above scenario, investors
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4. might be satisfied to accept today's tighter spreads if they believe spreads will remain at these levels, and not
widen. If so, that 5-yr PepsiCo bond at +25 bps over the 5-yr treasury is still providing investors with an
additional pick-up of 25 bps in yield. From a historical perspective, value in corporate-land remains in (1)
finance names (banks, brokerage, and insurance), (2) lower rated 'Baa' industrial issues, and (3) bonds that
trade with a 'story', i.e. companies that are improving as the economy continues to heal. But buyer beware,
spreads in all of these sectors have tightened a lot, and the easy lay-up trades have already occurred.
The Barclays' Corporate Index provided investors with a return of 1.82% in April vs. .30% in March. But
excess return was less, +52 bps vs. +128 bps. in March. Intermediate maturity bonds gained 1.34% and
generated 45 bps of excess return; while longer maturity issues gained an impressive 3.28% and had 71 bps
in excess return. Utilities led the way with a 2.35% return, and excess return of 78 bps. Industrials followed
with a 2.01% return, and excess return of 63 bps. Lagging behind were financials at +1.37%, and excess
return of 28 bps. As has been the case for the past 18-months, lower rated issues (“Baa”) posted the best
returns. They gained 2.22%, and had excess return of 85 bps. “A” and "Aa" rated bonds followed with
identical 1.76% returns. However, "Aa" rated issues outpaced their "A" rivals with excess returns of 61 and
46 bps respectively.
Companies sold $33.7 billion of junk bonds in April, a record for the month, with borrowers rushing to issue
before investors pull back from the riskiest securities. Moody's Investors Service says issuance may rise
10% this year, while investment-grade sales drop 7%. While issuance soars and cash streams into the
market, yields on junk debt rose in the last week of April for the first time since the end of February,
according to Bank of America data. The rise underscores concern that Europe's growing fiscal crisis and an
investigation into Goldman Sachs Group may slow the economy. "Companies are trying to come in before
the market dries up", said Kingman Penniman, President of KDP Investment Advisors. Tom Murphy,
portfolio manager and sector leader at RiverSource Investments, said "The market is getting whipped around
by the three Gs: Goldman, Greece and the Gulf".
Speaking of junk, prices of junk bonds have rallied so strongly over the past year that a key market
benchmark suggests that they are collectively trading near 100 percent of face value, a level not seen since
before the credit crisis took hold in 2007. A widely followed Merrill Lynch high-yield index hit a record low of
54.78 in mid-December, 2008. In comparison, it was trading at 99.55 at month's end.
As in recent months, April’s new issue calendar primarily consisted of lower rated credits (mostly junk),
financial issues, and private placements (144-A deals). The list of new industrials included: Avery Dennison
(Baa2/BBB) 10-yr at +150 spread, Lorillard Tobacco (Baa2/BBB-) 10-yr at +300 spread, Lowes Companies
(A1/A) 10-yr at +80 spread, Nordstrom Inc. (Baa2/BBB+) 10-yr at +100 spread, Thermo Fisher (Baa1/A-) 5-yr
at +75 spread, and Worthington Industries (Baa2/BBB) 10-yr at +262 spread.
Finance names that priced debt included: BB&T Corp. (A1/A) 6-yr at +140 spread, BNP Paribas (Aa2/AA)
5-yr at +82 spread, Regions Financial (Baa3/BBB-) 3-yr at +350 spread, Royal Bank of Canada (Aaa/AA-)
3-yr at +50 spread, and Tyco International Finance (Baa1/ A-) 5.5-yr at +95 spread.
Mortgage-Backs:
The Fed has acquired more than $1 trillion worth of mortgage-backed securities in the past 15-months. The
challenge they face today is how and when they can shrink a bloated balance sheet, which includes a lot of
these securities. But MBS analysts claim sales of these issues aren't likely soon. Reason being, the
markets are on edge because its holdings are so large. At $1.1 trillion in holdings of mortgage debt
guaranteed by FNMA, FHLMC and GNMA, the Fed owns roughly a fifth of all these outstanding instruments.
The sheer size of the portfolio makes these decisions so key. The Federal Reserve Bank of N.Y. estimates
Fed purchases of mortgage and treasury bonds pushed long-term interest rates down about 50 bps. The
mere announcement of sales could have the opposite effect, as investors price in future sales. On a
reassuring note, Bernanke made his preferences clear in February before Congress. "I currently do not
anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after
policy tightening has gotten under way and the economy is clearly in a sustainable recovery".
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5. Of note, mortgage delinquencies fell in March for the second month in a row, another encouraging sign for
the U.S. housing market. However, the WSJ reported that houses with loans of $5 million or more will likely
see a sharp rise in foreclosures this year.
The Barclays MBS Index returned .60% last month versus .03% in March. However, excess return was
negative at 11 bps. vs. March's positive 50 bps. Fannie 30-yr paper outperformed Fannie 15-yr collateral,
with returns of .46% and .36% respectively. 30-yr paper had 30 bps of negative excess return, while 15-yr
bonds had 14 bps of negative excess return.
In late April, mortgage finance giant Freddie Mac said the average rate on 30-yr fixed-rate mortgages fell
slightly to 5.06% (without fees and points) from 5.09% in late March. Compared to a year earlier, 30-yr rates
were 28 bps higher than April 2009’s 4.78% level.
The Fixed Income Market Update includes data, references and excerpts from the following
sources:
• ABC News
• Bank of America Merrill Lynch
• Barclays Capital
• Bloomberg
• Citigroup Inc.
• CNNMoney.com
• CNBC
• Financial Times
• Google
• The Economist
• The New York Times
• The Wall Street Journal
For Internal Use Only. Not for Distribution to the General Public. Page 5

6. Of note, mortgage delinquencies fell in March for the second month in a row, another encouraging sign for
the U.S. housing market. However, the WSJ reported that houses with loans of $5 million or more will likely
see a sharp rise in foreclosures this year.
The Barclays MBS Index returned .60% last month versus .03% in March. However, excess return was
negative at 11 bps. vs. March's positive 50 bps. Fannie 30-yr paper outperformed Fannie 15-yr collateral,
with returns of .46% and .36% respectively. 30-yr paper had 30 bps of negative excess return, while 15-yr
bonds had 14 bps of negative excess return.
In late April, mortgage finance giant Freddie Mac said the average rate on 30-yr fixed-rate mortgages fell
slightly to 5.06% (without fees and points) from 5.09% in late March. Compared to a year earlier, 30-yr rates
were 28 bps higher than April 2009’s 4.78% level.
The Fixed Income Market Update includes data, references and excerpts from the following
sources:
• ABC News
• Bank of America Merrill Lynch
• Barclays Capital
• Bloomberg
• Citigroup Inc.
• CNNMoney.com
• CNBC
• Financial Times
• Google
• The Economist
• The New York Times
• The Wall Street Journal
For Internal Use Only. Not for Distribution to the General Public. Page 5