High-Quality Bonds in 2011 Saw Best Performance Since 2002: LPL’s Valeri

High-quality bonds in 2011 posted their strongest returns since 2002, with last year’s performance even better than in 2008 when Treasury prices soared in response to the financial crisis, said Anthony Valeri, LPL Financial’s market strategist, on Wednesday.

For 2012, Valeri predicted, lower yields imply lower returns but high-quality bonds will likely hold firm “until clarity emerges on how successfully European bond issuers are able to refinance maturing debt.”

The impressive performance from high-quality bonds came as Europe dominated investors’ attention and two classic drivers of bond yields, the Federal Reserve and inflation, took a back seat, Valeri wrote in his note, “A Look Back, A Look Ahead.”

“The main difference in 2011 was the better performance of investment-grade corporate bonds, which increased in price compared to notable price declines in 2008,” Valeri said. “Make no doubt about it, however, Treasuries stole the show in 2011 and led performance with price strength evident by the 1.4% decline in the 10-year Treasury yield, from 3.3% to 1.9%. Intermediate Treasury yields start 2012 at the lowest levels since the early 1950s.”

In a total returns chart for 2011, Valeri noted that Treasury inflation protected securities (TIPS) saw the highest returns, at 13.6% for the calendar year, followed by municipal bonds, at 10.7%, and then U.S. Treasuries, at 9.8%. Investment-grade corporate bonds figured in the middle of the pack, ending the year at yields of 8.4%.

The poorest performers were bank loans, which yielded 1.1%, preferred stocks, 1.9%, and hedged foreign bonds, 4.0%.

The Fed’s most dramatic 2011 move was its announcement that it will keep interest rates low through the middle of 2013, Valeri said. “This unprecedented step greatly reduced interest rate risk for intermediate and long-term Treasuries and helped boost prices.”

Looking ahead in 2012, he said, the challenge posed by Europe will be most evident in the refinancing needs of European government bonds and European bank bonds.

“The ability of France, Spain, and Italy, as well as large European banks, to roll over maturing debt will be a crucial test of whether recent measures by European Union leaders, and the European Central Bank, with its new three-year lending facility, will prove satisfactory.

Read Outlook 2012: Fixed Income View From AXA, BondDesk, LPL & Eagle at AdvisorOne.com.