We look at how the bond markets have performed during the third quarter of 2010

As we distil our thoughts for this quarterly review, it is difficult not to concentrate on Western government bond yields and particularly those in the US. Whichever financial asset class an investor is committed to, all roads lead to the benchmark yield on Treasuries as this is the risk-free rate around which prices are set and typically the discount rate around which investors value future cash flows, whether they be dividends, rental income or coupons. The 10-year US Treasury yield should reflect the market's expectation of what the average Federal Reserve (Fed) funds rate will be over the coming decade, plus an appropriate term premium and inflation premium. The Fed funds rate has historically averaged 2.5% and long-term inflation expectations are currently around 2% which, ignoring a term premium for investing in a 10-year security, suggests a Fed funds rate of 4.5%. The benchmark 10-year US Treasury yield has fallen from 2.95% in June to 2.48% by the end of September, which indicates market expectations are for interest rates to be much lower than historically, and for a longer period too. This makes sense insofar as the US consumer is undertaking an extensive period of deleveraging and the drag on aggregate demand this will create means the Fed should offset this by keeping rates low.

Or is something else also at play? The term premium referred to in the paragraph above - the additional yield an investor should enjoy for the uncertainty around the future level of inflation - has fallen to almost zero for 10-year US government paper. This is indicative of investors buying bonds ahead of a further tranche of market intervention by the Fed in the form of quantitative easing, now commonly termed QE2. Clearly, it can be argued this anticipation of the Fed's next move has pushed rates artificially lower while assets priced relative to this yield are artificially high. We should ask ourselves whether this is exactly what the Fed wants to achieve as higher asset prices create a positive household 'wealth effect' and consumers will spend more money. The answer has to be 'yes'.

For fixed income investors, this third quarter of 2010 has been characterised by the ebb and flow of sentiment around the likelihood of QE2, which, in turn, has been driven by economic and corporate newsflow. Despite strong corporate earnings, declining default rates and the further strengthening of balance sheets - positive news for investors in corporate credit, particularly high yield - US economic data has been disappointing during this reporting period. By telegraphing its intention to do whatever it takes to arrest falling inflation expectations and create jobs, the Fed has stimulated a rise in asset values, particularly during September.

Investing in bonds has therefore remained a popular and profitable trade for global investors and flows into the asset class continued to be at elevated levels through the quarter. The search for yield underpins this although commentators have become increasingly vocal in recent months that a bond 'bubble' has been building. From a valuation perspective, developed market government bonds have become expensive relative to equities, however, the bond universe is very diverse and sound fundamentals as well as powerful demographic changes offer support to a number of areas in the fixed income arena.

Investment strategy

Fixed income markets have been volatile through this quarter - though far less than equities - as the 'risk on/risk off' sentiment pattern has defined the mood of market participants. This period of volatility has not come as a surprise to us, and our current strategy anticipates this pattern to continue through the remainder of this year and into 2011. Spreads on Irish and Portuguese debt rising to record levels is evidence European sovereign default worries are set to continue and this will cast a shadow over the regional banking sector. The opaqueness of the outlook, initially centred on the possibility and, thereafter, around the timing, size and scope of a further round of quantitative easing, led us to increase diversification and slightly temper risk within our portfolios.