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Q2 bond update: solid returns

Returns may be more modest in the near term; consider a more cautious approach.

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Bond markets provided solid returns again this quarter. The investment-grade bond market as measured by the Barclays Aggregate Bond Index gained 2%. U.S. corporate high yield fared slightly better, up roughly 2.5%. Non-U.S. bonds were even stronger, with emerging markets up roughly 4.5% and developed nations up 5.5%. For the first half of the year, the Aggregate Bond Index was up approximately 4%. For comparative purposes, U.S. stocks were up more than 7%. This correlation may surprise some investors. It reflects the unique global bond market conditions that exist today, including unprecedented central bank intervention, and a long, but exceedingly slow, economic recovery.

From a macro perspective, there have been several major factors that have driven the global bond rally this year, including:

  • Weaker-than-expected economic growth and generally low inflation
  • A clearer commitment from the Fed to keep monetary policy accommodative
  • Aggressive monetary easing from other major central banks
  • Renewed geopolitical concerns, including Ukraine and Iraq
  • Strong demand for bonds from large institutional buyers

Fed action

Recent actions from the Fed have been in line with expectations, meaning the taper is on track and the Fed is telegraphing the third quarter of next year for the first potential rate hike. Inflation has ticked up a bit and reduced any deflation fears, yet remains well contained. On paper, labor conditions have started to improve, with an average of 270,000 jobs added each month in the second quarter. The unemployment rate is already approaching the Fed's year-end forecasts. However, the decline in the jobless rate reflects both job gains and a historically low labor force participation rate. Many of the recent gains were also in low-wage and part-time jobs.

The Fed remains committed to addressing their dual mandate of supporting maximum employment and price stability. However, they remain challenged because economic growth has been below both expectations and their own forecasts. First-quarter GDP growth was revised to negative 2.9%, leading to a high likelihood for sub-3% growth for all of 2014. This is shaping up to be the fourth straight year of disappointing growth. Continued weakness in the economic expansion is likely to support a low rate mentality at the Fed for at least the rest of this year and a very gradual pace of tightening when it does.

Outside the United States

We cannot just look at the U.S., of course. As the Fed has begun to reduce their stimulus, other major central banks have been increasing theirs. Notably, in June, the eurozone cut rates and enhanced their bank-lending facility as they continue to struggle with low growth and deflationary pressures. The eurozone is still hampered by structural imbalances between member nations which contributed to their recent debt crisis. Meanwhile, Japan has continued their own quantitative easing (QE), also trying to fend off deflation.

One result of this accommodative global monetary policy is that U.S. Treasury rates actually appear attractive compared to the yields in other developed nations. For instance, the U.S. 10-year rate is approximately 2.5%, while the current German equivalent is roughly half that at 1.25%. The Japanese 10-year government bond yields just over one half of one percent.

This has helped contribute to strong demand for U.S. bonds. Large foreign buyers have been drivers of demand on the short end of the corporate curve while insurance companies and pension plans have continued to invest in the long end. In addition, geopolitical tensions have renewed a safe-haven bid for bonds and the flight-to-quality trade for U.S. Treasuries.

Overall, I believe the preceding factors help explain the bond rally so far in 2014. Generally speaking, underwhelming global growth, global government intervention and strong demand for yield product have put downward pressure on rates.

Outlook

What does this mean for bond markets looking ahead? There is no question that lower yields and tighter credit spreads are giving some investors pause. However, conditions should remain relatively constructive for bond markets. Specifically, U.S. bond markets should be supported by:

  • Beneficial supply and demand conditions
  • Positive, but low, economic growth
  • Generally solid credit metrics and low default rates
  • Low prepayment rates and low volatility in the mortgage markets
  • Accommodative global monetary policy
  • Unattractive global bond yields

That is not to say there aren't concerns. For instance, there remains great uncertainty regarding the implementation of Fed policy and how it will impact markets. There is no precedent for the Fed's multitrillion- dollar intervention directly into capital markets. Therefore, it's hard to say exactly what will happen when it is fully unwound. One benefit of quantitative easing has been lower market volatility. If volatility were to spike at some point, it could certainly disrupt both bond and stock markets. We have already seen some disruptions in emerging market flows.

Other concerns include a potential housing crisis in China, further economic struggles in Europe, geopolitical unrest and tight credit spreads. Idiosyncratic risk is also becoming a greater concern at these richer spread levels. For instance, there is greater vulnerability to negative event risk for bondholders.

Overall, market technicals and economic conditions should remain supportive and allow bonds to continue generating positive total returns. However, given the strong start to the year, returns may be more modest in the near term. With credit spreads and interest rate volatility near the lower end of their respective ranges, we believe a more cautious approach to risk taking is warranted.

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The views and opinions expressed by Bob Brown are as of 7/15/2014 and do not necessarily represent the views of Fidelity Investments. Any such views are subject to change at any time based on market or other conditions and Fidelity disclaims any responsibility to update such views. These views should not be relied on as investment advice, and because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund. Neither Fidelity nor the speaker can be held responsible for any direct or incidental loss incurred by applying any of the information offered.
Past performance is no guarantee of future results.

Portfolio Review is an educational tool.

Diversification/asset allocation does not ensure a profit or guarantee against loss.
Barclays Aggregate Bond Index is a market value–weighted index of investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of one year or more.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market, or economic developments, all of which are magnified in emerging markets.
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 and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
Any fixed income security sold or redeemed prior to maturity may be subject to loss. Investments in mortgage securities are subject to the risk that principal will be repaid prior to maturity. As a result, when interest rates decline, gains may be reduced, and when interest rates rise, losses may be greater.
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