Ongoing uncertainty stemming from the European sovereign debt crisis and impending U.S. fiscal cliff supported demand for fixed-income securities during the third quarter. However, stimulative policy actions by global central banks and the search for higher yields pushed investors further out on the credit spectrum. Securities perceived as holding higher risk outperformed so-called safe-haven assets as investors sought better rates than those available from government debt. Yields on 10-year U.S. Treasury notes fell below 1.4% during the quarter, marking a new all-time low, but closed at 1.88% after the Federal Reserve announced a third round of quantitative easing. Meanwhile, corporate spreads continued to narrow.

The Fed’s decision to extend its timeline for exceptionally low short-term interest rates and launch another round of bond-buying were widely anticipated by the market. Nonetheless, the program’s mandate to purchase agency mortgage-backed bonds came as a surprise and fueled a rally in these securities. Our taxable portfolios, which get about a third of their duration from mortgage-backed securities, benefited from the move.

The central bank’s actions (and promise to introduce additional measures as needed to support improvements in the labor market) eased worries about the strength of the U.S. economic recovery. But the effect may be short-lived. Unless policymakers can introduce new legislation before year-end, the Bush-era income tax cuts and other key provisions will expire, several new taxes will be imposed, and spending cuts will be triggered. Adding to pressures on Congress, Moody’s warned that if the U.S. fails to stabilize its debt-to-GDP ratio in 2013, the country’s credit rating will be downgraded.

Municipal bonds performed well during the quarter despite recent well-publicized bankruptcies by some high-profile U.S. cities. These cases affirmed our long-standing belief that extensive research and exhaustive analysis are the most effective protection against troubled issuers. In fact, we have typically favored revenue-backed bonds with easily identifiable revenue sources. This has allowed us to avoid exposure to cities and counties with questionable and difficult-to-analyze financial reporting. Furthermore, the future financial soundness of a local municipality’s general purpose bonds can be extremely difficult to predict, as their creditworthiness relies heavily on whether elected leaders enact policy decisions that support the interests of bondholders. For these reasons, we prefer to own revenue bonds that are protected in the event of a bankruptcy rather than risking exposure to the potentially vulnerable credit quality of specific cities.

Accommodative monetary policy has consequences, and recent actions from the Federal Reserve are likely to increase inflationary pressures. Most members of your portfolio management team believe there is sufficient unused capacity in the economy for inflation to remain low in the near term. Nevertheless, the team is vigilant in monitoring the macroeconomic picture in an effort to make sure that the overall portfolio structure is well positioned to withstand the eventual increase in rates.

The low-rate environment has made it challenging to find attractive yields. However, bonds remain a crucial component of client portfolios. As we enter the final quarter of 2012, volatility could intensify as the deadline for the U.S. fiscal cliff approaches. Fixed-income managers will continue to construct portfolios in a manner that focuses on capital preservation and risk mitigation. As a hedge against unexpected inflation, they have increased holdings of Treasury Inflation-Protected Securities in short-term national and California municipal portfolios. Certain revenue bonds have also been added to municipal portfolios. In intermediate and short duration taxable accounts, managers have increased positions in mortgage-backed securities, which are expected to continue to benefit from the Fed’s latest quantitative easing measures. As ever, your portfolio management team will continue to closely monitor the yield curve, actively managing credit exposure and carefully controlling duration in an effort to generate return at a modest risk level.  n

The thoughts expressed herein are current as of September 30, 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. 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 your Investment Counselor. Past results are no guarantee of future results. © 2012 Capital Group Private Client Services. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited.