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Anthony Valeri, CFAMarket Strategist LPL Financial

LPL F INANCIAL RESEARCH

Bond Market Perspectives

Two weeks into the fourth quarter of 2011, the bond market appears to have made a U-turn with Treasury yields higher and investment-grade corporate and high-yield bonds outperforming(according to Bloomberg data). A look into the Treasury market reveals that the bond market has begun to price in better economic growth and higher inflation going forward. The fourth quarter of 2010 was the last time the yield on the 10-year Treasury yield rose by 0.4% or more over a period of two weeks or less. However, we do not think recent market action augers for an exact repeat of the fourth quarter of 2010 when Treasury yields rose steadily, and markedly, higher. Several factors suggest that any repeat of the fourth quarter of 2010 is likely to be more modest in magnitude.

From a low of 1.75% on October 3, 2011, the 10-year Treasury yield has increased by 0.4% over the past two weeks as investors began to remove the safe-haven premium embedded in Treasury prices. A combination of better economic data and progress towards a more robust solution to address the European sovereign debt problem helped drive Treasury yields higher. Over the past two weeks, top-tier economic data releases such as the Institute of Supply Management (ISM) manufacturing survey and monthly employment report have exceeded consensus forecasts. The consumer has proven resilient with monthly retail sales also surpassing forecasts and spending on big ticket items, such as autos, stronger than expected. In sum, economic data has contradicted recession fears and helped push Treasury prices lower and yields higher over the past two weeks.

In Europe, leaders continue to take concrete steps towards a more robust solution. The expanded European Financial Stability Facility (EFSF) was ratified by all 17 EU countries and although the size of the facility is viewed as too small by some market participants, the fact that all 17 countries pressed forward indicates willingness to support the euro. Nonetheless, it is likely the powers of the EFSF will be enhanced in some way, either by increasing the size of the facility or using it to insure debt from troubled euro-zone debt issuers. In addition, private holders of Greek government bonds will likely be subject to a greater loss of principal than the 21% detailed in the EFSF terms. A more aggressive approach by EU leaders is viewed as necessary to limit the threat to European banks and the broader financial system.

The improved tone is visible in the Treasury Inflation-Protected Securities (TIPS) market. The yield on the 10-year TIPS increased by 0.2% after hovering

October 18, 2011

Bond Market U-turn

HighlightsTwo weeks into the fourth quarter of 2011, the bond market appears to have made a U-turn with Treasury yields higher and corporate bonds outperforming.

The fourth quarter of 2011 is starting out on the road taken by the bond market during the fourth quarter of 2010, but we believe the results — higher Treasury yields and corporate bond outperformance — to be more modest than a year ago.

1 Higher Growth Expectations Are Reflected In Higher TIPS Yields

Source: Bloomberg, LPL Financial 10/14/11

Aug11

Sep11

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Oct11

Jul11

May11

Apr11

1.0%0.9%0.8%0.7%0.6%0.5%0.4%0.3%0.2%0.1%0.0%

-0.1%

10-Year TIPs Yield

BOND MARKET PERSPECTIVES

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near 0% for most of September [Chart 1] indicating the bond market is pricing in better economic growth. Similarly, the inflation rate implied by current 10-year TIPS pricing shows that inflation expectations increased by 0.2% as well [Chart 2]. Both measures are subdued in a historical context and indicative of slow growth, but nonetheless reflect improvement in economic expectations going forward.

Despite efforts to flatten longer-term yields through Operation Twist, the Federal Reserve is likely to be pleased with higher Treasury yields and recent messages from the TIPS sector. The better economic growth and higher inflation expectations (often a natural by-product of growth) implied by the TIPS sector is a sign that the Fed’s medicine may be working. The Fed is trying to spark risk-taking in financial markets and that is typically accompanied by higher Treasury yields. Yields on high-yield bonds have decreased since the start of the quarter thereby lowering borrowing costs for lower-rated companies. Similar to the moves in TIPS, the high-yield improvement is modest given the magnitude of summer weakness but still represents the strongest two-week performance run since October 2010, a very strong month (and ultimately quarter) for high-yield bonds.

However, while there are some similarities, we do not expect a repeat of the fourth quarter of 2010. We do expect a modest additional increase in Treasury yields over the remainder of the year, taking the 10-year Treasury yield to about 2.5%, and believe corporate bonds, investment-grade and high-yield, will perform better than Treasuries. Four reasons stand out as to why the fourth quarter of 2011 will likely be more muted compared to the fourth quarter of 2010:

§ A Federal Reserve on hold – The Fed’s commitment to remain on hold through the middle of 2013, which was announced at the conclusion of the August Fed meeting, is the greatest difference between the fourth quarter of 2011 and this time last year. The Fed has historically been a primary driver of interest rate changes, but by remaining on hold this source of interest rate risk has been greatly reduced.

§ Slow growth – Consensus forecasts for below-trend 2.0 – 2.5% economic growth over the coming quarter, and perhaps beyond, will also limit upward pressure on Treasury yields.

§ Low inflation – Although inflation has accelerated noticeably over the past year to an annualized rate of 3.8% through the end of August, inflation is expected to stabilize and then decelerate in 2012. Overall inflation, as measured by the consumer price index (CPI), is forecast to slow to an annualized pace of 2.1% by the end of 2012, according to a Bloomberg survey of 76 economists. Forward-looking bond markets will likely take note of benign inflation risks in 2012, which reduces upward pressure on interest rates.

§ Less government spending – Automatic budget cuts are coming even if the budget super-committee cannot agree upon specified spending cuts. Again here the bond market will look forward and view reduced government spending as a modest deterrent to economic growth in 2012, which in turn will also reduce upward pressure on interest rates.

2 Inflation Expectations Have Increased As Well

Source: Bloomberg, LPL Financial 10/14/11

Aug11

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2.8%

2.6%

2.4%

2.2%

2.0%

1.8%

1.6%

10-Year Breakeven Inflation Rate Implied by 10-Year TIPs Yield

Market Inflation Expectations

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BOND MARKET PERSPECTIVES

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This research material has been prepared by LPL Financial.

The LPL Financial family of affiliated companies includes LPL Financial and UVEST Financial Services Group, Inc., each of which is a member of FINRA/SIPC.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

The Federal Open Market Committee action known as Operation Twist began in 1961. The intent was to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. The action has subsequently been reexamined in isolation and found to have been more effective than originally thought. As a result of this reappraisal, similar action has been suggested as an alternative to quantitative easing by central banks.

Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity and redemption features.

The ISM index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.

Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.

Treasury inflation-protected securities (TIPS) help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the Consumer Price Index - while providing a real rate of return guaranteed by the U.S. Government.

The U-turn the bond market has initiated to start the fourth quarter of 2011 may have more road ahead but we do not expect the same journey as the fourth quarter of 2010 when 5- and 10-year Treasury yields increased by more than 0.7% and high-yield bonds outperformed Treasuries by just over 5%, according to Barclays Index data. We believe the results — higher Treasury yields and corporate bond outperformance — to be more modest than a year ago.