Recent news has resulted in heightened sensitivity to risks inherent in the fixed income markets; however, our philosophy remains unchanged. We view fixed income as an asset class to generate current income and help mitigate equity market risk. Based on current market conditions (the level of yields, risk premiums, and recent ratings actions) we don’t feel a need to alter our core philosophy and buying parameters as it relates specifically to fixed income.

Although it’s difficult for investors not to focus on the recent (mostly) downside volatility in the equity markets, the fixed income markets have had an equally eventful period and significant price movements also. Two events over the past three trading days will have important and ongoing impacts on the credit markets.

First was the S&P downgrade of the U.S. long-term debt rating to AA+, the first time that the rating has not been AAA by all major domestic ratings agencies. S&P referred to many political issues in its rationale for the downgrade. Clearly, the growing debt-to-GDP levels and the recently agreed-to fiscal consolidation plan, which falls short of what many feel is necessary to make a meaningful impact on the longer term debt dynamics, are a mid-to long-range concern for the credit markets.

The U.S. remains one of the highest-rated sovereign credits in the world. Market-based indicators currently price the ‘credit’ risk of the U.S. ‘very low,’ with only Switzerland, Sweden, and Norway priced as better credit risks. By this measure, the markets view the U.S. as a better credit than England, Germany, Japan, and China, among others. While the downgrade is a ‘credit’ event, it also potentially has ramifications for the yield levels going forward. On a positive note, S&P remarked that the U.S still has a “very strong capacity to meet its financial commitments…and it differs from the highest rated obligors only in small degree.” S&P left the short-term rating at A-1+, the highest money market rating.

As a result of S&P’s action, there has been and will be a ‘waterfall’ effect on related issuers, with many other government-related issues also being downgraded to AA+. S&P also lowered the AAA ratings on municipal bonds tied to the federal government, like housing securities and debt leases.  Nine states are currently rated AAA by S&P and 13 by Moody’s, but five are expected to be downgraded based on their reliance on the U.S. government. However, only state issued bonds would be downgraded and, even with the drop, all of the states (South Carolina, Tennessee, Maryland, Virginia and New Mexico) will still be very highly rated. Moneta constantly reviews its buying criteria and monitors positions for credit risk. We remain confident in our buying parameters, even in the wake of recent news.

The second meaningful bond market event was the Fed’s announcement that it expects to leave interest rates unchanged, at least into mid-2013. If the Fed does not move interest rates until then, cash and other short-term fixed options will continue to yield very little. Farther out the yield curve, this is one factor that will help keep a lid on bond yields. The 10-year Treasury hit an intraday low of 2.04 percent this week. While we aren’t comfortable forecasting yields at a time of heavy government/central bank intervention globally, currently the conditions don’t appear to argue for a protracted, meaningful increase in yields above what we have seen the last couple of years.

The Fed has signaled a willingness and ability to enact QE3 (third round of quantitative easing) if necessary and, globally, yields are trending down, providing less competition for capital. It should also be noted that Treasuries have seemingly retained the ‘safe haven’ status they offer in times of equity volatility. These developments argue that yields will remain relatively contained during this time of uncertainty and slow growth.

In a very low yield, tight risk-premium environment, fixed income provides low returns, and we aren’t comfortable ‘stretching’ to add yield. Instead, we feel investors needing to generate additional return beyond what fixed income can currently provide need to realize that is an asset allocation decision, which changes the risk/reward dynamics of a portfolio. If and when market conditions change, we will adjust accordingly, as we always strive to do.