Quarterly Market Update
Fixed Income Outlook
Risk Exposure on the Rise
The 1-10 year U.S. Treasury Index has the longest duration and lowest overall coupon rate it has ever had. As a result, the Treasury market has more potential downside price volatility than we have ever seen, and investors could easily experience some bond market losses in 2015 if rates do indeed go up.
The Fed exited its six-year bond purchasing program in October, thus removing itself as a mega buyer of government debt. Still, the Fed will continue to support Treasury and Agency bond prices to the extent it will have to reinvest considerable cash flows from over $4 trillion in bonds currently held on its balance sheet. Yields were widely expected to rise as a result of the tapering. However, global economic weakness and tumbling oil prices (i.e., lower inflation) allowed yields to fall throughout the year. The yield on the 10-year U.S. Treasury stood at 2.62% in September but rallied through the fall months, dropping below 2.0% on one occasion in October before closing the year at 2.17%. The U.S. Treasury yield curve flattened – yields on the front end rose in anticipation of Fed tightening while yields on the long end fell in response to lower inflation and safe- haven buying by foreign investors. Treasury securities maturing in one to 10 years returned 2.82% in 2014, the largest rally in that portion of the yield curve in three years. Most of the appreciation was driven by falling yields on longer maturity securities.
Figure 1. Yields were widely expected to rise in 2014, but declined overall throughout the year.
Estimates are that the 10-year U.S. Treasury yield is currently 50 to 75 basis points lower than it would be were it not for strong demand by foreign investors seeking yields that are more attractive than the ones they can find at home and a currency (U.S. dollar) that offers refuge from depreciation in the Euro and other global currencies. At the precipice of a deflationary cycle and teetering on the brink of another recession, yields on Eurozone sovereign debt have plummeted. The yield on the 10- year German Bund fell from 1.08% on September 12 to close 2014 at 0.54%.
Figure 2. Yields on 10-year sovereign debt declined sharply as global growth weakened and inflation levels fell.
In the U.S., the most recent core consumer inflation report showed a year-over-year increase of 1.7% annualized, below the Fed’s stated target of 2%. Inflation overseas is expected to turn negative in the near future. Central bankers, with the exception of the Central Bank of Japan, do not have a great deal of experience dealing with deflation. Japan has struggled for years to extract itself from the deflation cycle. As a result of falling inflation and weakening economic growth, the Merrill Lynch All Maturity German Government Bond Index returned 9.04% in euro terms in 2014.
Price volatility in the Eurozone bond market is to some extent tied to perceptions that the ECB’s monetary policy alternatives are hamstrung by the Maastricht Treaty signed in 1992 which originally united Europe. According to the Treaty, the ECB cannot buy government debt directly, as the Fed has successfully done for the past six years in the U.S. The ECB has been attempting to do a workaround in order to jumpstart growth whereby it has bought government debt in the secondary market for the past year and a half. However, yields on European debt have fallen so low that investors question whether the next ECB bond-purchasing program, expected to be announced in late January, will be successful in stimulating economic growth.
Corporate Bond Performance Tracks that of U.S. Treasuries
Corporate bonds, as measured by the Merrill Lynch U.S. Corporate 1-10 Year A-AAA Index, returned 4.20% in 2014, outperforming the intermediate Treasury sector. In comparison, the Merrill Lynch U.S. Treasury 1-10 Year Index returned 2.82%. The difference in the return of the two indices was a function of higher interest rates paid on corporate debt and not a function of a major change in credit spread performance. So, for the most part, it was a fairly typical year.
Corporate bond spreads widened a bit in December, driven wider by safe-haven buying in Treasuries on the heels of economic weakness in the Eurozone and declining oil prices. (Some investors fear that the dramatic decline in oil prices may be foreshadowing more weakness in global economic growth that has yet to be detected by others means). New bond issuance also contributed to some spread widening in December as corporate CFOs rushed to take advantage of low yields by issuing bonds. The corporate bond market has experienced three consecutive years of record high new issuance, culminating with $1.4 trillion in new investment-grade bond issuance in 2014.
Figure 3. Key fixed income asset class returns 2012-2014.
High yield bonds underperformed investment grade debt in 2014 as indicated by the 2.50% return on the Merrill Lynch U.S. High Yield Index. The credit tightening seen during the summer unwound as the year concluded, resulting in the worst return on high yield bonds since 2008. Performance on high yield bonds suffered late in the year with the drop in oil prices because many issuers of high yield debt are in the energy sector. With respect to the high yield/junk sector, the lower the credit rating, the weaker was performance in 2014.
Municipal Bonds Benefit from Declining Interest Rates
Performance in municipal bonds in 2014 was largely driven by declining interest rates which pushed prices higher, although reduced supply and improving credit quality also contributed to appreciation. Municipals enjoyed a scarcity premium in 2014 as there was insufficient supply to satisfy demand. Relative to the corporate bond market, investor yield grab was rewarded in the municipal market. Improving credit quality led to investor willingness to purchase bonds rated down the credit curve. As a result, lower-rated credits performed better than higher rated credits. Credit spreads tightened throughout the year as the spread between A- and AAA-rated municipal bonds declined as much as 20 basis points.
Consensus calls for the yield on the 10-Year U.S. Treasury Note to end 2015 in the neighborhood of 2.75%, up from 2.17% at the end of 2014.
The outlook for yields in 2015 is divided into two camps – those who believe interest rates will be driven higher by Fed rate hikes in response to stronger domestic economic and employment growth, and those who believe tepid growth overseas and global deflation will delay the Fed from tightening or limit the amount of tightening that can realistically be implemented. We do not expect 2015 to be a repeat of 2014 given that yields are historically low. The 1-10 year U.S. Treasury Index has the longest duration and lowest overall coupon rate it has ever had. As a result, the Treasury market has more potential downside price volatility than we have ever seen, and investors could easily experience some bond market losses in 2015 if rates do indeed go up. With respect to the former camp, consensus calls for the yield on the 10-Year U.S. Treasury Note to end 2015 in the neighborhood of 2.75%, up from 2.17% at the end of 2014.
The timing of Fed tightening is critical, and the current consensus calls for a hike in the Fed funds rate in June 2015. However, at the December FOMC meeting, the Fed dropped the year-end 2015 Fed funds rate projection from 1.375% to 1.125%. Given that the Fed funds rate currently stands at essentially zero, this scenario requires considerable tightening in the second half of the year. However, the one-year Fed funds futures contract is currently trading 62.5 basis points below the 1.125% Fed estimate, indicating that investors are skeptical about the timing of rate increases.
Chairwoman Yellen holds that the price of oil is transitory, and that it cycles through the system. As such, the largest determinant of the Fed’s potential to raise interest rates is the strength of the domestic economy, most importantly, employment growth. Third-quarter 2014 GDP growth was revised up to 5.0% and if that pace continues, coupled with over 250,000 monthly payroll gains and an unemployment rate in the mid 5% range, then the Fed will likely tighten in 2015.
Geopolitical issues could flare up as they do most years. If the price of oil continues to fall, it will cause problems for oil dependent economies like Venezuela, Iran, and Russia that are propping-up their societies with oil revenue. The extent of the oil price decline will be primarily determined by whether it is a demand or a supply issue. (See the Q&A which follows for a full discussion of the current plunge in oil prices.) The plunge in oil prices has been particularly impactful because of the degree and speed of the descent. Markets are better equipped to handle significant change when the change is not so sudden and sharp.
Currently, U.S. interest rates are among the highest in the developed world which has led to strength in the U.S. dollar. All other things equal, rising rates in 2015 may make the dollar even stronger. The strengthening U.S. dollar hurts American corporate earnings overseas, but it helps foreign holders of our debt because it cushions the blow if U.S. interest rates rise and bond prices fall.
Performance of Mortgage-backed Securities May Weaken
The mortgage market performed strongly in 2014, returning 6.07%, supported by the Fed’s purchases under the quantitative easing program that ended in October. Without the Fed’s sponsorship in 2015, we do not anticipate mortgages to do as well going forward.
Status Quo for Corporate Bonds
As long as the economy and earnings are improving, we should not expect any big changes in investment-grade corporate bond market credit spreads. Performance in the high-yield bond market will be sector specific - continued weakness in the energy sector and commodities space would weigh on junk bonds.
Municipal Bond Supply to Increase
In 2015, we expect municipal bond supply to increase such that a dearth of supply is no longer as supportive a factor for tax exempt bond prices as it was in 2014. In fact, 2015 could see an excess of supply driven by pent- up demand for capital infrastructure projects which have been on hold since 2008. Now that state and local budgets are stronger due to increasing tax revenue, municipalities are becoming more willing to take on projects and issue debt. Likewise, while the yield grab was beneficial to municipal bond prices in 2014, we do not anticipate that being the case in 2015 if yields begin to rise as expected and the fear of missing-out on available yield diminishes.
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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.
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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).