The uncertain environment fueled continued demand for fixed-income securities throughout the year even as economic improvements and accommodative monetary policies helped ease worst-case-scenario fears. The general decline in rates contributed to solid appreciation across the spectrum of municipal and taxable fixed-income securities for 2012, with longer-maturity bonds and lower-rated securities benefiting as investors demonstrated a willingness to assume more risk in the pursuit of higher yields. Corporate high-yield bonds gained the most, rising 3.3% during the fourth quarter and 15.8% for the year. Treasuries declined in the three-month period ended in December but advanced 2% during 2012.

In this environment, many investors are enticed by the appeal of higher-yielding, lower-quality bonds. When such exposure is warranted, it should be managed within the context of one’s overall risk capacity and risk tolerance. To the extent that high-yield municipal bonds are desirable and suitable, an active approach underpinned by diligent research is essential, particularly given the current challenges facing local governments. In the case of taxable bonds, investors have flocked to lower-quality corporate bonds in their quest for yield, resulting in excellent results for the sector over the short term, but making the asset class expensive relative to its higher-quality counterparts.

Municipal bonds continued to do well despite a spate of highly publicized bankruptcies earlier in the year. Our avoidance of these problematic holdings is a testament to the exhaustive research and in-depth analysis we conduct when making investment decisions in this opaque sector. Because it can be difficult to obtain accurate reporting information from municipalities, we continue to favor high-quality revenue-backed bonds issued by local governments that have transparent revenue sources and revenue streams that will continue to flow even if the entity declares bankruptcy. Revenue bonds account for the vast majority of all holdings in our municipal portfolios.

Extremely supportive measures by the Federal Reserve have artificially depressed yields on short-to intermediate-maturity Treasury bonds. As a result, investors are paying more for the perceived safety of high-quality securities or, if they wish to access higher interest rates, accepting additional risk in exchange for higher income. In such an environment, an active approach that monitors and manages changes in rates and credit quality is crucial. Although most members of the portfolio management team believe there is sufficient unused capacity in the economy for inflation and interest rates to remain muted in the near term, they are monitoring macroeconomic factors and the political environment in anticipation of an eventual period of rising rates.

At the Fed’s most recent policy-setting meeting, members identified specific thresholds that must be hit before they would implement a rise in interest rates, saying that short-term federal funds rates will remain in the zero to 0.25% range until the unemployment rate falls below 6.5% or inflation threatens to exceed 2.5%. This shift to economic targets gives the central bank more flexibility in the event of unexpected economic strength, though this is not of immediate concern given the significant deficit reduction required of Washington in the near term. The Fed voted to purchase $45 billion of Treasury bonds each month to replace its Operation Twist program, which expired at the end of the year. The central bank will also continue to purchase $40 billion of mortgage-backed securities on a monthly basis.

Our portfolio management team constructs portfolios with the objectives of promoting capital preservation and mitigating risk. Currently, portfolios have slightly longer durations than they did previously because managers expect bond yields to remain weak as the government continues to deleverage. However, the team is prepared to adjust portfolios and reduce maturities when there is greater confidence that rate increases are on the near-term horizon. As an additional protection, managers have been adding Treasury Inflation- Protected Securities and floating-rate municipal issues as a hedge against possible inflation.

The high level of macroeconomic uncertainty has created unprecedented demand for fixed-income securities as investors have sought their perceived safety. As a result, yields have trended lower, increasing the risk posed by rising interest rates at some point in the future when confidence returns and economies are more robust. Interest rates are expected to remain subdued at least through 2013; however, bonds are still a desirable component of balanced portfolios, serving to offset equity volatility that may arise in the near term as developed economies work through deep-seated fiscal challenges.

The thoughts expressed herein are current as of December 31, 2012, are based upon sources believed to be reliable and are subject to change at any time. There is no guarantee that any projection, forecast or opinion in this paper will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with an Investment Counselor. © 2013 Capital Group Private Client Services. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited.