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Charles Sandmel, CFP®, AIF® | Portfolio Manager

The bond market rally ended abruptly in the fourth quarter, with total index returns marginally up on the taxable side (+0.20%), and down slightly on the municipal side (-1.21%). Still, 2009 produced very strong returns overall (5.93% taxable, 9.80% municipal).

The rapid deceleration in the fourth quarter recognizes that the economic downturn, which had sent investors scurrying to the relative safety of bonds, had run its course, and that recovery—usually associated with higher rates/lower prices for bonds—appeared to be waiting in the wings.

Weaknesses were apparent in longer maturity bonds and U.S. government obligations. Such weakness in the U.S. government market arises from a number of sources:

• the prospect of lingering deficits which must be financed with bonds,
• a concern that the low-rate policies that pass for stimulus may end, and
• the relative attractiveness of the debt of other nations.

When long-term rates are much higher than short-term rates, it means that all interest rates are likely to rise. Weakness in bonds is often associated with (expected) stock market rallies, such as the one experienced between March and the end of 2009, as investors reallocate away from bonds to stocks.

If the expected economic recovery that has caused the stock market rally is truly imminent, reports of real progress are fairly well hidden. Although housing sales volume appears to have troughed, prices have not advanced materially, and while mortgage rates are low, credit standards remain high. Regional housing markets, especially in the South and Southwest are still in deep trouble.

Employment, which we expect to revive only after the economy picks up, is still in the dumps, and managers are wringing productivity increases out of already overworked staff, rather than hiring new people.

At the same time, improvement in some economic sectors is more or less inevitable. Replacement of depreciated or obsolete capital goods such as computers, vehicles, and other machinery and equipment cannot be delayed indefinitely. The economic stimuli applied by government will likely bear some visible fruit in 2010. And with the leading edge of the baby boom reaching retirement age, we may see a demography-driven improvement in labor supply and demand in the years just ahead.

During the past two years, many investors fled the stock market for the safety and higher returns of bonds, or allocated significantly more of their portfolios to bonds. Looking forward, if the budding economic recovery becomes real and sustainable in 2010, it is likely that interest rates could rise from current historic lows, which would drive bond prices down. Prudence suggests that investors with overweight bond allocations should carefully review their fixed income allocations in light of this newly forming reality.

We have consistently advocated treating bond investments as defensive, and not trying to make them heroic. That means sticking with high quality, relatively simple products, not reaching for high yield by sacrificing quality or locking up funds for long periods of time. Weakness in local government finances makes our ongoing caution even more important in the municipal bond market. The economic and market conditions we see today do not encourage us to move away from this strategy.

Charles Sandmel, CFP, AIF, is a First Affirmative Investment Advisory Representative. A 30-year veteran portfolio manager and past Director of the National Federation of Municipal Analysts, Mr. Sandmel manages fixed-income separate accounts for First Affirmative clients.