- Total returns for the broad bond market year to date are within our midyear forecast of low- to mid-single-digits.
- Sectors that we liked, including mortgage-backed securities (MBS), investment-grade corporates, high-yield bonds, and bank loans performed well, though staying neutral on emerging market debt (EMD) was a miss.
- We did not anticipate the steep rise in rates following the U.S. presidential election, leading to the 10-year Treasury yield exceeding our forecast.
As the year winds down, our weekly commentaries have reviewed how 2016 forecasts played out, and we do the same this week with a review of fixed income. The year 2016 saw extremes in the bond market, such as low to negative rates overseas, along with major macro events (e.g. the Brexit vote) that pulled U.S. rates lower during the first half of the year, until the 10-year Treasury reached an all-time low of 1.36% in July. From then on, improving economic data and rising inflation expectations helped push rates modestly higher, before they spiked on hopes of tax reform and pro-business policies following the election in November, and again moved higher following last week’s Federal Reserve (Fed) interest rate hike.
Here we review what we got right, as well as the misses for fixed income in 2016.
WHAT WE GOT RIGHT
Bond Market Forecast
"Our expectation is that average intermediate-term Treasury yields rise by approximately 0.25% to 0.50%, with a lesser probability of a 0.75% increase possible." – Midyear Outlook 2016
We started the year with our Outlook 2016 calling for flat returns for bonds, with expectations of a 0.25-0.50% increase in the 10-year Treasury yield from its November 2015 level of approximately 2.25%. Our rate forecast turned out to be in line with reality (the 10-year Treasury yield closed at 2.54% on 12/19/16), but the path to higher rates was unexpected. Given the low rate environment at midyear, we upgraded our total return view to low- to mid-single-digits in our Midyear Outlook. The Bloomberg Barclays Aggregate Bond Index has returned 1.52% as of 12/16/16, making it likely that full year total returns may finish within that updated range. We expect the 10-year Treasury yield to end 2017 in the mid 2% range, with a potential for more upside if meaningful stimulus is enacted. Scenario analysis based on this potential interest rate range and the duration of the index indicates low- to-mid-single-digit returns for the Bloomberg Barclays Aggregate Bond Index.
MBS and Investment-Grade Corporate Bonds
"Amid historically low yields, intermediate bonds, with an emphasis on mortgage-backed securities and investment-grade corporate bonds, provide diversification benefits and a favorable trade-off between yield and interest rate risk." – Midyear Outlook 2016
"MBS are fairly valued but offer the potential for additional yield relative to duration when compared with other high-quality options." – “Time to Buy Mortgages?”Bond Market Perspectives, May 17, 2016
A strong environment for credit and higher yields than the Bloomberg Barclays Aggregate Bond Index has helped investment-grade corporate bonds (+4.70%, Barclays Aggregate Credit Index as of 12/19/16) outperform the broader bond market year to date. MBS had a tough first half of the year as rates moved lower, but their lower duration (interest rate sensitivity) and higher yield per unit of duration helped them outperform the broader bond market in the second half of the year, as the 10-year Treasury yield climbed from all time lows reached in July (-1.59% for the Barclays Securitized MBS index versus -1.76% for the Barclays Aggregate Index from 7/8/16 through 12/19/16). Moving forward, we continue to believe that investment grade corporate bonds offer value relative to Treasuries. One risk factor to watch for MBS is that as rates rise, fewer people refinance, which could lengthen the average maturity of mortgage loans and increase duration of MBS. However, the yield per unit of duration remains attractive at this point in time, and we maintain a positive view of MBS.