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Bonds

September 2010

The increasingly gloomy outlook for the US economy dominated government bond markets during August. A big downgrade of future economic prospects by the Federal Reserve, combined with higher jobless numbers and disappointing housing market statistics, has heightened fears that the global recovery is losing steam.

In response, the Fed unveiled plans to reinvest back into the Treasury market the proceeds of its book of mortgage-backed securities. While this is not another round of quantitative easing, it maintains the liquidity that resulted from earlier such operations.

The action sent a strong signal to markets that there would be no US interest rate rises in the near future. Benchmark interest rates were left on hold in August by the Bank of England and the European Central Bank at 0.5% and 1% respectively.

In the wake of the gloomy US statistics, “core” government bonds were the main beneficiaries of equity-market nervousness . The benchmark ten-year US Treasury yield touched a succession of 16-month lows before finishing the month at 2.47%. UK gilt and German bund prices rose as their ten-year yields charted a similar downward path, hitting all-time lows and ending August at 2.83% and 2.12% respectively. The latter fall in yields came in spite of indications that the German economy remained in good health. The ten-year Japanese Government Bond yield was also down, reaching its lowest level in seven years.

Investors switched out of peripheral European government bonds as sovereign debt concerns returned to the market with a vengeance. The spread between Irish and German ten-year yields hit a record high after Standard & Poor’s downgraded Ireland’s credit rating. Meanwhile, the Greek-German sovereign spread widened to more than 900 basis points.

The disappointing US economic data took the wind out of the corporate bond market’s sails. As a result, the recent rally stalled slightly in August, although the asset class still produced positive total returns.

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Scottish Widows Investment Partnership Limited (SWIP) is registered in England and Wales, Company No. 794936. Registered Office is at 33 Old Broad Street, London EC2N 1HZ. Tel: 0131 655 8500. SWIP is authorised and regulated by the Financial Services Authority and is entered on their register under number 193707 (www.fsa.gov.uk).