After the hot stock market last year, investors generally figured bonds would take a backseat to stocks again this year. So it was unexpected when bonds outperformed stocks in the first quarter of 2014.
Viewpoints spoke with Tom DeMarco, CFA, a market strategist in Fidelity’s Capital Markets fixed-income division, to discuss what drove bonds’ strong first-quarter performance—and whether it’s likely to continue.
Bonds posted relatively strong returns during the first quarter of 2014. Was that unexpected?
TOM DEMARCO: It certainly was counterintuitive. When we ended the year, everybody was talking about a great rotation away from bonds and toward stocks. But in the first quarter, bonds beat stocks handily on a total-return basis. Soft U.S. economic data in late December, January, and February, concerns about China’s economy, global growth in general, and comments by Janet Yellen, the new chair of the Federal Reserve, about when the Fed might begin raising interest rates, took some of the air out of the stock market. While all that was happening, there were solid fund flows into the fixed-income market, because of investors’ demand for yield. So yields continued to be pushed down in the first quarter, leading to relatively strong performance in the bond market.
Another taboo at year-end—long duration—was the main driver of returns in the first quarter, due to the substantial “bear flattening” of the yield curve. A bear flattening is when the short end of the yield curve rises more than long-term interest rates.
Do you expect bonds’ performance to continue?
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DEMARCO: I don’t. I think improving economic numbers are going to be the main headwind for the fixed-income market. A recent positive retail sales report, jobless claims at or near cycle lows, and a rebound in factory orders are among the items that indicate to me that GDP growth should start to strengthen from here, and that may help pull rates higher, leading to weaker or negative returns in the fixed-income market.
Geopolitical and macroeconomic issues could pose a risk to that outlook, however. One concern is that Japan’s recent consumption tax hike could sap that country’s economic momentum and draw it back into recession. That could have some spillover effect in other Asian markets, such as asset flows out of risky assets and into safe havens like bonds, which in turn could have some spillover into global markets. Meanwhile, China is trying to rein in excess credit growth while simultaneously maintaining economic growth above 7%. I think that will be a difficult task, and could also have some spillover effect in emerging markets if it’s not handled properly. And, of course, there’s the geopolitical situation in Ukraine. If some sort of agreement is reached, the de-escalation of tension may be positive for stocks and other risk assets. But if the situation escalates, that could be a problem for risky assets, and we could see a renewed bid for safe-haven assets such as Treasuries and high-quality corporate bonds.
What’s your outlook for interest rates?
DEMARCO: I expect that the tapering is going to continue at the current pace and that the Fed could be done with its quantitative easing program by December. My outlook for interest rates has stayed the same: I expect the yield on the 10-year Treasury to end the year around 3.5%.
As far as the Fed raising interest rates, the markets are pricing in a 65% probability of the first rate hike taking the federal funds rate to 0.5% by July 2015. I do think that policy will slowly be normalized. But I agree with some of the Fed members who think that the fed funds rate will likely remain below long-run average levels for some time.
The market reacted negatively to Janet Yellen’s comments in the first quarter that seemed to put a timetable on when the Fed would begin raising interest rates. Was that reaction appropriate?
DEMARCO: From my perspective, the market overreacted to Yellen’s remarks. Likewise, I think the market overreacted in the opposite direction to the minutes from the Federal Open Market Committee released earlier in April. As the Fed withdraws its stimulus, I think the fixed-income markets are going to work their way back to a more normal level of volatility. Ultimately, I think that is healthy, but it certainly could be a bit unnerving for investors who have become accustomed to lower-than-normal volatility and a 30-year bull market in bonds.
Municipal bonds had a strong first quarter. What drove their performance?
DEMARCO: A lot of it was related to municipal bonds generally being a longer-duration product than, say, high-yield bonds. Despite this “handicap” in a rising-rate environment, municipal bonds may outperform Treasury bonds on an excess return basis (return versus a duration matched basket of Treasury securities) due to what I see as favorable technical factors over the intermediate term. One of these factors is a lack of meaningful supply in the market. Our internal forecast for municipal bond supply is about $285 billion this year. When you factor in redemptions, we’re actually looking at a negative net supply situation for the year. Furthermore the peak summer months are also the peak months for coupon payments and maturities (collectively called redemptions) and this year looks fairly heavy with north of $100 billion in redemption money (source: MuniView) to be put back to work. Meanwhile, from a credit perspective, the muni market remains stable, and we continue to see improvement at the state and local levels.
While this may be a bit technical and possibly obvious to some, I think it is worth noting that while municipal bonds can outperform Treasury bonds on an excess return basis, that does not mean the total (or absolute) return for the sector will be positive. Given that thought, if my outlook on rates is correct, keeping duration in check could limit any downside from that scenario.
What’s your outlook for high-yield bonds?
DEMARCO: The good news is that corporate balance sheets are still fairly healthy, credit quality overall is stable, default trends remain low by historical standards, and I expect them to remain fairly low over the next couple years.
That said, high-yield valuations appear to be stretched. In fact, the option-adjusted spread of the high yield index in March hit its lowest point in nearly seven years. We’re at valuation levels where it’s hard to get very excited about adding high-yield exposure. Spreads can continue to grind tighter, but I think we’re probably near the terminal phase of tightening. From a longer-term perspective, you may not be getting paid enough for the risk you’re taking on. In general for fixed income, I think upside is much more limited than downside risk from this point on.
What does that mean for investors? I think it means that you take a more diversified approach to fixed income in general. Given my prior comment about limited upside, diversifying across a broad spectrum of fixed-income sectors may improve risk-adjusted returns.
Where are you seeing opportunities?
DEMARCO: One area is BBB-rated investment grade bonds, which are the lowest level of investment grade. On a spread basis, the BBB sector looks attractive relative to AA- and A-rated securities. I believe that continued recovery in the economy also could favor lower-quality bonds.
Broadly speaking, Europe is an opportunity because its interest-rate cycle is at a slightly different point than ours. If my forecast is correct, interest rates in the U.S. are headed higher, but Europe’s economic recovery is still a bit tentative, and interest rates are going to be much slower to rise. In fact, there’s talk that the European Central Bank may embark on quantitative easing, which could be beneficial for fixed-income products in Europe. One place to look is among investment-grade European corporate bonds, particularly if the European economy continues its tentative recovery.
I also see some opportunities among investment-grade emerging-market corporate issues (U.S.–dollar denominated). But I would caution that investors are probably better served getting exposure to emerging-market debt through a diversified mutual fund as opposed to choosing individual securities.
The market seems to be sending mixed signals to bond investors. Are bonds a good place to be right now?
DEMARCO: To me, keeping a well-diversified portfolio is essential, and that means always having some exposure to fixed-income securities. You can hone that exposure—whether by extending or lowering your duration or by increasing or decreasing your credit risk—depending on your outlook and your risk tolerance.
These days, I’d rather take on some credit risk than duration risk. Corporate America is still fairly strong, credit trends are stable, and default rates are low—and should stay low in the intermediate term. And the economy is likely to continue growing at a moderate pace, which I think is positive for spreads.
Past performance is no guarantee of future results.
Diversification and asset allocation does not ensure a profit or guarantee against loss.
Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
The municipal market can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest income generated by municipal bonds is generally expected to be exempt from federal income taxes and, if the bonds are held by an investor resident in the state of issuance, state and local income taxes. Such interest income may be subject to federal and/or state alternative minimum taxes. Investing in municipal bonds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets. Generally, tax-exempt municipal securities are not appropriate holdings for tax advantaged accounts such as IRAs and 401(k)s.
In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.
High yield/non-investment grade bonds involve greater price volatility and risk of default than investment grade bonds.
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