Connect with us

Fixed Income

An Important Year for Bond Investors

Published

This is an important year for bond investors. After ten long years the markets are now offering yields on ultra-safe one year treasuries above the inflation rate, as measured by Personal Consumption Expenditures (PCE).  Over the last decade if we wanted to keep up with inflation we needed to take risk longer out on the yield curve or with higher risk bonds.  Funds flow data shows investors are attuned to these better yields and are moving funds to short-term high quality bond strategies.

The small downside to rising rates is flat to slightly negative total returns on high quality assets. However, total returns are likely to move closer to current yield levels once the Fed has finished normalizing rates, absent a recession. Market consensus is that the Fed has already completed most of the heavy lifting and there are fewer rate increases ahead of us than behind us.

There is always an argument to hold safe bonds in a portfolio, but now the decision is far easier.

Chart 1: One Year Treasuries Finally Above Inflation

(1) Assumes federal tax rate of 32%

Interest Rates

After the late September Federal Open Market Committee (FOMC) meeting the fed funds rate is now targeted to be 2.00-2.25%. This is a large increase from what was close to zero as recently as late 2015. For 2018 it is anticipated we will have 4 rate increases in the fed funds rate, which could make this year the most aggressive period of rate increases during the normalization process.  In 2019 the FOMC is projecting the fed funds rate to be a little higher than 3.0%, but the markets are more skeptical and think the Fed will need to dial back on rate increases for a number of potential reasons including slower domestic growth, emerging market weakness, or some other unforeseen event.

Related: Why Investors Care so Much About a Few Dots

Related: Contagion and U.S. High Grade Credit Markets

Municipals

Municipals continue to lead returns in 2018 as good technical trends are supporting performance. The 2017 tax reform bill reduced the supply of municipal bonds, as this law eliminated the ability for municipalities to issue advance refunding bonds on a tax-exempt basis. Less supply with steady demand has created a favorable technical backdrop. On top of these good technicals, strong fundamental credit quality adds to the attractiveness of municipals.

Corporates

This has been a bumpier year for corporates than for municipals. Credit spreads are slightly wider over the course of the year as the market anticipates that corporate earnings are peaking, spreads are historically tight and higher supply due to M&A activity could occur. With spreads slightly wider and overall yields more attractive, we are finding good opportunities in short-maturity corporates that should produce positive returns over treasures even if corporates widen modestly from here.

Overall  

Our outlook for the rest of the year and into 2019 is similar to what has occurred year-to-date.  The Fed is likely to continue raising the fed funds rate, the economy will continue to grow above potential due to still accommodating monetary and fiscal policy, yet domestic and geopolitical headlines will continue to buffer markets and investors will continue to speculate just how much longer this economic cycle has to run. But with short-term yields now above the inflation rate, high quality bonds offer good value and safety.

Sources: ICE/BAML Indices

Continue Reading

Trending