Quarterly Market Update
Fixed Income Outlook
Bond Market Marks New Era
December was a watershed month for bonds, perhaps signaling the end of a three-decade long bull market rally. The Federal Reserve (the Fed) ended months of speculation when it announced a data-dependent exodus from its current bond buying program, signaling confidence that the U.S. economy is improving. After eight years at the helm, Chairman Ben Bernanke prepared to hand to incoming Fed Chairman Janet Yellen the leadership of the great unwind of quantitative easing that has swelled Fed coffers from $1 trillion to over $4 trillion. Yellen will take office February 1. Congress hammered out a template for a bipartisan $1 trillion budget agreement that for the first time in years broadly sets spending priorities from top to bottom, while reversing some of the steep sequester cuts scheduled for 2014. Appropriation of that budget was subsequently signed by President Obama on January 15.
Investors pushed interest rates higher at the prospect of an improving economy and reduced Fed support for Treasuries and mortgages. The rotation out of bonds into equities intensified. Coming off low yields and long durations, the change was powerful from a price performance perspective, although not so much in terms of a jump in interest rates. In 2013, bond returns as measured by the Barclay’s Aggregate Bond Index, declined for the first year since 1999.
The fourth quarter was characterized by rampant credit spread tightening. The flight to safety in U.S. Treasury bonds common after the credit crisis of 2007 quickly turned into a dash to corporate credits. As investors piled into the corporate market from all directions, spreads tightened across the curve, particularly in the two-to-five year space, although the impact was felt all the way to the 10-year. Lower quality and longer maturity bonds offered the best credit spread contraction in all the major sectors. Corporate bonds as measured by the Merrill Lynch U.S. Corporates 1-10 year, A-AAA Index outperformed U.S. Treasuries, but posted a negative return for the quarter due to the overall rise in interest rates.
Figure 1. The growing demand for yield caused spreads to tighten. For example, Hewlett-Packard (HPQ) is a BBB+ name that often provides a wide spread. However, it substantially tightened in the 10-year area relative to a AA name, in this example Wal-Mart (WMT), and to the 10-year Treasury as investors searched for yield in the last quarter of 2013.
The yield on the 10-year U.S. Treasury rose to 3.03% at yearend in light of the Fed's plans to reduce bond purchases by $10 billion per month beginning in January and likely exit the bond buying program entirely by the end of 2014. The Government Agency sector of the market dwindled in the front end of the curve with Agencies offering little spread over Treasuries. After the original mid-year tapering comments, the 30-year mortgage rate peaked at 4.875% although it ended the year at 4.625%, up from 3.625% in January. For the quarter and the year, Agencies narrowly outperformed Treasuries, although both ended the periods with negative total returns.
The municipal market was plagued by over 30 consecutive weeks of mutual fund outflows, each exceeding a billion dollars. Municipals ended the year mostly flat after new issuances combined with selling in the secondary market pressured bond prices. Nonetheless, municipals as measured by the Merrill Lynch Municipals 1-10 Years, A-AAA Index narrowly ended the quarter and the year in the black, outperforming U.S. Treasuries and Agencies, but slightly trailing corporate bond returns.
The figure above represents the overall tightening trend in the U.S. Agency market in the last three months of 2014.
Outlook – Yields Will Drift Upward Gradually
Looking ahead, we do not anticipate that credit spreads will widen materially. Indeed, it would take a significant credit event to widen spreads, but as the U.S. economy improves the likelihood of such a crisis dissipates. Most businesses have already refinanced outstanding debt and are largely flush with cash. Corporate earnings are gradually improving so that the threat from an earnings implosion seems limited. Uncertainty regarding new healthcare laws, tax rates and the general economy could continue to weigh on business investment and act to constrain bond issuance.
The situation is similar in the municipal bond market. Not only is the newissue supply calendar limited, but so is the availability of bonds in the secondary market. The refunding market has almost evaporated as bonds that were eligible have been refunded, removing another segment of supply.
ISI Research is calling for the yield on the 10-year Treasury to be at 3.5% by the end of 2014, up from 3.03% at the end of 2013. While we concur that the natural drift is upward, we anticipate that it will be a slow drift and one whose ascent is carefully orchestrated by the Fed. The Fed has a vested interest in keeping interest rates low in that higher debt service costs on Treasuries drives the budget deficit higher. In fact, 6.40% of the budget deficit is simply interest expense. It is thought that a general rise in Treasury yields of as much as 1% would dramatically increase the budget deficit to the point of being prohibitive. Rising public debt service costs are damaging to the private sector to the extent they starve it of the capital needed to fuel economic expansion.
In our opinion, municipal bond yields could rise at a slower pace than taxable yields throughout the year as municipal buyers, driven by higher federal income tax rates, return to the bond markets earlier, willing to accept a certain level of yield and hold their bonds to maturity.
Figure 3. Total returns by fixed income asset classes – Treasuries, Agencies, Corporates and Municipals over the fourth quarter compared to 2011, 2012 and 2013.
The biggest hurdle for the taxable bond market is that investors are well aware that short term-rates are likely to rise by sometime in 2015, and therefore there is little opportunity cost in waiting. Indeed, spreads on the front end of the curve have become extremely tight because that is currently the favored parking spot.
The road to economic recovery has followed anything but a smooth trajectory. Events could still conspire to alter the extent and pace of the planned tapering. Inflation levels above 2% would allow more aggressive tapering, but levels have remained below that target for some time because there is no wage-push or demand-pull inflation. Energy prices are down which is another deflationary aspect. In fact, deflation appears to be more of a threat than inflation as excess capacity, elevated unemployment rates and globalization have put downward pressure on prices.
The current unemployment rate of 6.7% has historically only been seen during recessions. Despite the Fed’s efforts to increase the wealth effect by pushing investors into riskier assets as part of monetary stimulus, benefits have accrued disproportionately to the well-educated, while the income gap for the middle class, blue-collar, non-college graduates has grown. Should the GDP growth rate slow from the Fed’s projection of 2.5%, then more, rather than less, stimulus could be in order. Finally, congressional discord could again increase market volatility although political wrangling does appear to have been moderated by the recent bipartisan agreement.
As the Fed commences the process to normalize interest rates, it will do so at a measured pace that promotes price stability for bonds while continuing to run an accommodative monetary policy that will keep short rates low for some time to come. For investors, the diversification afforded by bonds will continue to be important especially as retirement time approaches. Investors will continue to search for yield which will keep credit spreads tight while helping simultaneously to contain long rates.
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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).