Themes:
- U.S. Interest Rates: We expect 10-year rates to fall over the first few months before reversing course once the Fed starts to raise rates mid-year.
- U.S. Bonds: A duration-neutral barbell approach utilizing short duration bonds and funds (including floating rate notes) and longer-dated maturities should outperform the aggregate. This can be captured through the use of both credit and Treasury bonds. We recommend clients remain flexible and stand ready to adjust duration dependent on economic news.
- Municipal Bonds: While municipals should remain the asset class of choice for tax-sensitive investors, we view the market as slightly overvalued and expect spreads to widen slightly this year.
- High Yield: We view the recent oil driven sell-off in the high-yield market as a buying opportunity for active management. The active approach allows managers to buy industries and bonds that offer the most attractive relative value and credit fundamentals compared to a passive approach which merely tracks the index.
- International Bonds: Pockets of opportunities will exist but we remain concerned that a stronger U.S. dollar will offset gains in local currency bonds.
The Backdrop
2014 surprised many bond investors as interest rates fell dramatically on the longer end while they rose as expected on the short end. The result was another solid year of returns for investors that remained in longer-duration bonds, and was adequate for most investors that shortened their duration.
Long-dated bonds were the best performing financial asset in 2014, as most 20-plus year indices were up over 25% while the “Core” bond market, as measured by the Barclays Aggregate, was up nearly 6%.
As the end of quantitative easing becomes a reality in 2015, and despite a backdrop of global headwinds and a stronger dollar, our fixed income team expects the Federal Reserve to remain steadfast on raising rates mid-year. Unfortunately the pace of these increases remains in question. The two most likely scenarios would be: (1) the Fed starts to raise rates earlier (June) and then does so at a deliberate pace (likely every other meeting) or (2) the Fed waits (3rd quarter or later) for inflation to return to target levels and then raises at a more rapid pace. We feel the odds are high that the first scenario will be more likely, and market friendly, as a swift rise in rates would be unfavorable to market participants as equity market volatility would increase while the bond market would realize losses at an elevated pace. In the end, both scenarios point to higher short-term rates by the end of 2015.
While the front end of the yield curve moves higher, there is evidence that the Fed is using the blueprint that Greenspan used in 2004 in an attempt to moderate long-term interest rates. That year, the communication from the Fed was very similar to the current language going into the year as rates were also at “all-time” lows (Fed Fund Rates were 1% vs. 0% to 0.25% today). In January of 2004, the Fed removed the “considerable period” language from its message and rate liftoff happened in June. When we look at the economics, there is no reason to believe this won’t be the case again this year. When one looks beyond the media coverage, it is apparent that the economy is on much better ground today than back in 2004.
Specifically, the 3-month trend in private payroll growth was under 100,000 then vs. over 250,000 today. In addition, underlying income growth appears to be healthier today, 1.3% then vs. 5% today—calculated by the year on year change in Aggregate Hours Worked Index multiplied by Average Hourly Earnings (source: Bureau of Labor Statistics). Lastly, unemployment is falling much faster today than back in 2004. The improvement in the unemployment rate is at a pace that has not been seen since the mid-1980s. Look for the labor story to become the main driver when the Fed explains why rates need to be raised. Chairwoman Yellen has increasingly become a “labor hawk” worried that allowing unemployment to fall too far will inevitably create inflation. She has stated that this is not what the policy intends to create.
The global headwinds (and probable stronger U.S. dollar) will remain a headline risk to rates throughout the year. The current 150 basis point spread between U.S. Treasuries and German Bunds has remained constant as of late, but we view this as temporary. In the near term, the fear that the ECB could force European rates even lower (or negative) will also push U.S. rates lower, but by mid-year we feel the combination of diverging central bank policies (U.S. will be tightening while Europe will be loosening monitory policy) combined with actual economic results will allow the spread to expand in 2015. It is abundantly clear that growth is stronger in the U.S., inflation is higher and confidence is stronger.
Foreign demand for dollars is playing a large role in this bond cycle. While we have not tried to quantify the impact from foreign investment, we estimate that roughly half of the risk premium being paid for U.S. assets is being caused by foreign monies. On this topic we look at two factors: (1) the duration of foreign holders tends to be much shorter than domestic demand, and (2) as the dollar strengthens, foreign investors will increasingly become nervous about buying USD bonds because of the potential for underperformance once other currencies regain their footing—assuming they do.
As a result, look for the spread to revert to wider levels, which means higher interest rates in the U.S. than in Europe, while the divergence allows the longer part of the curve to inch higher. The biggest downside risk to our forecast would be better-than-expected growth in Germany, which would lift both U.S. and European rates.
What to do now?
The continued strength of the U.S. dollar combined with domestic investors that are starving for yield should allow credit and longer bonds to perform adequately. As a result, we expect the yield curve to continue to flatten as the Fed starts to move rates higher while the longer end is kept under control due to external pressures. Consensus within the firm is for the Fed Funds target rate to end the year between 0.50% and 0.75% while the 10-year Treasury ends the year between 2.25% and 2.50%. Interestingly, the “FOMC Dot Plot” projections from the Fed point to a year-end rate of 1.125% while the Fed Funds futures are pricing in a year-end rate of 0.50%.
As a result, many of our discretionary accounts are utilizing a barbell strategy of pairing floating rate notes with longer-dated bonds to take advantage of the flattening. If correct, we feel the belly of the curve (3 to 8 years) will be under the most pressure as the year progresses. We feel rates will continue to decline during the first half of the year before stabilizing and rising once the Fed begins to move short rates higher.
We feel the slower pace of long end increases will also benefit high-yield bonds as lower-rated corporations will still have access to “cheap” money. That being said, it is important to understand the components of the high-yield market. Currently, energy makes up more than 15% of the Bank of America Merrill Lynch High Yield Index. While it is also obvious that the collapse in oil prices remains a risk, it also becomes important to understand what parts of this market your manager is buying. Within energy, exploration, production, oil field equipment and services are down close to 10% but other sectors such as gas distribution and oil refining have held up well during this downturn. As a result, we feel that investors will be rewarded by paying active managers the higher fees they demand over indexed ETFs in order to navigate through what we expect to be a volatile market. In the end, despite five years of solid returns, we still find value in high-yield market as yields remain above 6%, defaults remain low, and credit fundamentals remain sound.
Lastly and likely the most volatile part of the bond market will be the international markets. Here we expect the stronger dollar to reduce some index returns despite bullish bond fundamentals such as quantitative easing being implemented in Europe and continued in Japan. As a result, we feel pockets of opportunities will exist globally, but prefer to invest in funds that are managed from a U.S. dollar perspective, buy dollar-denominated foreign debt or utilize currency hedging to mitigate foreign currency risks.
