Investors and the capital markets quickly changed their focus in the second quarter with the concept of the Fed “tapering” or reducing its security repurchase program becoming the overwhelming central theme. The capital markets had expected the tapering of the repurchase program to be the first step in the Fed’s measured efforts to reduce quantitative easing, but the shock to the capital markets was the potential timing. The Federal Reserve surprised the markets by stating that it may begin reducing the security repurchase program over upcoming months and as soon as September, despite economic indicators being well short of target. Markets, generally speaking, do not like surprises and tend to act (or overreact) very quickly when unexpected events occur. This change in expectations defined the second quarter, leading to a strong elevation in U.S. Treasury rates and an increase in credit spreads. As a result, this environment proved difficult for bonds during the period as almost all sectors and bond indices posted negative returns. In other words, investors did not have a place to hide within the bond market during the second quarter other than in cash or money market funds. The broad domestic bond market, as measured by the Barclays Aggregate Bond Index (“Aggregate Bond Index”) posted a quarterly return of --2.32% bringing its year-to-date performance down to -2.44%. In contrast, the broad U.S. equity market, as measured by the S&P 500® Index, posted quarterly and year-to-date returns of 2.91% and 13.82%, respectively.
With U.S. Treasury yields adjusting to new expectations, the performance of the U.S. Treasury sector was negatively impacted by the rise in interest rates although the sector did outperform some other sectors during the quarter. U.S. Treasuries posted a quarterly return of -1.92%. Long-duration U.S. Treasuries, which are more sensitive to interest rate changes, were more negatively impacted, generating a quarterly return of (5.81%). The quarter ended with the 10-year U.S. Treasury and the 30-year U.S. Treasury rising sharply, yielding 2.49% and 3.50%, respectively, compared to 1.85% and 3.10% at the end of the first quarter.
Non-U.S. Treasury sectors did not fare any better. The U.S. investment grade (defined as credit quality of BBB- or higher) credit sector posted a quarterly return of -3.31%. All underlying segments of the credit market were negative with financial bonds performing the best at -2.78% while industrials and utilities were down (3.49%) and -3.99%, respectively. Demand for the sector declined as investors’ concerns over rising interest rates elevated which led to much lower flows into bond funds during the quarter.
U.S. agency mortgages, a large constituent of the Aggregate Bond Index, posted a negative absolute return of -1.96% for the quarter. Rising interest rates caused mortgage durations to extend during the period due to modifications in prepayment assumptions while concerns over mortgages supply/demand dynamics surfaced due to the potential tapering in the Fed’s purchases of mortgages.
High yield bonds (defined as below investment grade corporate bonds) posted a quarterly return of -1.44%, outperforming its investment grade counterparts. Spreads widened in this segment of the market despite evidence of modest economic improvement and strong corporate balance sheets. The higher yielding orientation of these securities helped offset price depreciation, limiting the impact to negative returns.
Emerging market debt suffered during the second quarter, generating a return of -6.22%. A strong U.S. dollar, lower commodity prices, slowing growth in China and fund outflows hurt the sector.
In summary, the bond market experienced a difficult period during the period primarily in response to the Fed signaling a tapering of its bond repurchase program. As a result, the bond market is attempting to revalue securities based on fundamentals and without the “distortion” of the Fed’s repurchase program. It may take some time for the capital markets to appropriately absorb this change in expectations and as a result, bond prices may be volatile. The good news is that the economic environment has possibly improved to levels that may warrant a reduction in quantitative easing.
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 Capital Management, a controlled affiliate of GuideStone Financial Resources, serves as the investment adviser to GuideStone Funds.