Principal Strategic Asset Management (SAM) Flexible Income Portfolio
Market Review and Investment Strategy for the Quarter Ended 6/30/2010
In "Flight to Safety," Treasuries Outperform
Risk aversion was apparent during the second quarter as many investors turned to the "safe haven" of U.S. Treasuries, which outperformed other fixed-income sectors. By quarter-end, the yield on the benchmark 10-year Treasury had fallen from 3.84% to 2.95%. (Bond prices and yields move in opposite directions.) Meanwhile, investment-grade corporate bonds fell -2.25% relative to duration-adjusted Treasuries. Returns were slightly worse in the financial segment of the corporate bond market (down 2.97% relative to duration-adjusted Treasuries), due in part to uncertainty and anxiety surrounding financial regulation reform. Commercial mortgage-backed securities and asset-backed securities also lagged Treasuries, while mortgage-backed securities managed to outperform Treasuries by just 0.01%.1 Finally, high-yield bonds returned -3.86% relative to duration-adjusted Treasuries, with the lowest-rated (highest risk) high-yield bonds performing the worst.2
Within U.S. Stocks, All Sectors Struggle
The broad U.S. stock market posted a return of -11.3% in the second quarter, as all sectors within the Russell 3000® Index delivered negative performance. The economically sensitive materials sector struggled the most. Financial stocks also were under acute pressure, as investors grappled with the changing landscape of regulatory reform and how it might impact the industry. Within this environment, growth and value performed similarly among large- and mid-cap stocks, while within small caps, value slightly underperformed growth. From a market-cap perspective, small caps outperformed large caps.3
International Stocks Also Plummet
International stocks in developed markets returned -14.0%,4 reflecting in part the precarious financial situation in Europe. Emerging markets performed better, but still delivered a total return of -8.37%.5
REITs Outperform Stocks for Quarter
Real estate investment trusts (REITs) returned -4.00%6 to outperform the broad U.S. stock market. Although real estate fundamentals were still unfavorable, access to capital for commercial real estate improved, which drew investors hoping to participate in the asset class's recovery.
REITs Lead Portfolio Performance
The Portfolio's allocation to REITs proved to be a primary contributor to relative performance, as this asset class outperformed the S&P 500 as well as its respective benchmark index. Although large-cap growth equities lagged their mid- and small-cap counterparts, exposure to this asset class added to relative returns, as the Portfolio's large-cap growth holdings outperformed their benchmark index. On the fixed-income side, the Portfolio's exposure to mortgage- and asset-backed securities was also favorable, adding to relative performance as they outpaced their benchmark index.
In an environment where bonds significantly outperformed stocks (as measured by the Barclays Capital Aggregate Bond Index and the S&P 500), the Portfolio's overweighted position in equities versus fixed income was a primary detractor from relative performance. Within fixed income, the Portfolio's exposure to high-yield corporate bonds detracted from relative performance, as this asset class underperformed the Barclays Capital Aggregate Bond Index as well as its respective benchmark index. The Portfolio's allocation to preferred securities also hurt relative returns, as the performance of this asset class lagged the Barclays Capital Aggregate Bond Index.
Summary of Active Asset Allocation Strategies
The Portfolio ended the quarter with an overall allocation of 73% fixed income and 27% equities, reflecting diversification across 16 asset classes. During this period the Portfolio:
- Continued to emphasize investment-grade and high-yield corporate bonds
- Held an overweighted emphasis on equity positions
- Maintained its slightly more aggressive target positions through use of cash flows, as appropriate, in response to market swings
1 Returns as measured by components of Barclays Capital Aggregate Bond Index.
2 Returns as measured by components of Barclays Capital High Yield Index.
3 As measured by the Russell family of indices.
4 As measured by the MSCI EAFE Index.
5 As measured by the MSCI EM Index.
6 As measured by the MSCI U.S. REIT Index.
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