The average spread in Morningstar's Corporate Bond Index tightened 5 basis points in January to end the month at +135. Credit spreads in the financial-services sector tightened 10 basis points, outperforming the industrial sector, which tightened 2 basis points. In our first-quarter 2013 outlook, we opined that the financials sector would outperform the industrial sector this quarter, and we continue to hold that view.
Within the industrials sector, basic industries and technology outperformed, tightening 11 and 8 basis points, respectively. As investors poured new money into fixed-income funds and exchange-traded funds (ETFs) and the economy continued its tepid recovery, portfolio managers were overweight with their purchases into these cyclical sectors. The energy sector underperformed in January as it widened 2 basis points, the only sector to widen over the course of the month, mainly because of shareholder activism in the sector.
While credit spreads tightened during the course of the month, corporate bond prices declined as interest rates rose. The 10-year and 30-year US Treasury bonds each rose 22 basis points, overwhelming the benefits from tightening credit spreads, resulting in a 0.73% decline in the Morningstar Corporate Bond Index. Based on movements in this index, it appears that many investors tried to dodge the effects of rising interest rates as demand for shorter-duration bonds pushed credit spreads of bonds with maturities under seven years tighter than longer-dated bonds. Bonds with maturities under seven years tightened 8 basis points as compared with a 2-basis-point tightening for bonds in the seven- to 10-year maturity range and 4-basis-point tightening for bonds with maturities over 10 years.
As we highlighted in our first-quarter 2013 outlook, it will be mathematically very difficult to enjoy anywhere near the double-digit returns investors enjoyed in 2012. To reach those types of returns, either credit spreads will have to return to the tightest levels recorded (February 2007) or interest rates will have to drop significantly below where they are currently trading, which is already near the lowest on record. Assuming corporate credit spreads tighten modestly and interest rates remain steady, in conjunction with the Morningstar Corporate Bond Index currently yielding 2.40%, investment-grade bonds appear to be poised to return the low- to mid-single digits in 2013.