Fixed Income Outlook: There's still value in spread product (just a little less)
If there were a phrase to capsulize what fixed-income investors should do this year, it’s “be vigilant.’’ It’s still a spread-product market, i.e., we continue to like taxable high-yield and investment-grade corporate bonds. But with economic growth on an upward trajectory and the Federal Reserve starting to ease off the gas, it’s become more of a relative play than an absolute play—that is, total returns may not to be as high as they have been because of the potential negative effects of rising interest rates. The bias on rates clearly is up for the year for a number of reasons:
Watch the Fed
First there's the Fed. The replacement of Ben Bernanke with the more dovish Janet Yellen as chairman would seem to suggest the Fed's going to be very slow to move to unwind the ultra-accommodative policies of the past five years. While policymakers have begun the end game for quantitative easing, with modest reductions in the $85 billion of monthly longer-term Treasury and agency security purchases starting this month, they also have signaled the benchmark funds rate may stay low beyond attainment of the 6.5% unemployment rate and 2% inflation thresholds. However, with the more hawkish Stanley Fischer presumed to become Fed vice chairman and with Richmond Fed President Jeffrey Lacker’s recent comments that the funds rate could begin to move as early as late this year, this "lower for longer'' mindset may not be set in stone.
Watch the economy
Then there's the economy. Real GDP expanded a much stronger-than-expected 4.1% in last year's third quarter, and while a similar print isn't expected for the fourth quarter, the data to date indicate GDP again may surprise to the upside, with the momentum carrying over into this year. There's some debate about the quality of growth—businesses continue to keep a tight rein on capital spending, much of the improvement on the employment front has been in lower-paying jobs, and higher mortgage rates and still-tight bank lending standards represent headwinds for housing’s recovery. Still, the reality is the debate isn't over growth, just how much, and that's a significant change.
The global growth story should be monitored as well. The eurozone is in the early stages of recovery, Great Britain is on the rebound and Japan is exiting a two-decade funk. The emerging markets are a little dicier. It may be more a story of individual markets than the sector as a whole this year, with the outlook improving in some countries such as Mexico while remaining uncertain elsewhere. A wild card is China, where a hard landing appears to have been averted but uncertainty reigns over whether it can actually meet its 7.5% growth target.
Watch fund flows
Finally, there is the issue of demand. Last year was a great year for equities but not fixed income, which saw the Barclays U.S. Aggregate Bond Index decline 2.02% on the year and, according to Investment Company Institute data, net investor flows into bond funds turned negative while flows into equity funds turned positive for the first time in years. It's debatable if this is the beginning of the so-called "Great Rotation'' from bonds to equities, but it's fairly obvious fixed-income demand isn't what it was.
Watch the yield curve
Given the spike in 10-year Treasury yields in late spring and summer, when even talk of taper pushed them up from a May 1 low of 1.61% to nearly 3% by late summer, we think a fair amount of this year’s likely move up in rates already is priced in on the longer end of the curve. It's the belly of the curve—the 4- to 7-year area in particular—that potentially will experience the most erosion as rates begin to rise. This is why we are keeping duration short at 85%. We're still positioned for a steepening curve, but wouldn't be surprised to shift to a flattening bias during the year. This argues for a barbell strategy that loads up on very short maturity securities and also holds longer-term securities—10-year maturities and out, where we think the relative move up in yields will be minimal. Ten-year yields may increase to the 3.5%-4% area, but that arguably would represent fair relative value given current low levels of inflation.
Overweights on high-yield, investment-grade and CMBS
While spreads—the gap between yields with comparable maturity Treasuries—have narrowed to historical medians and below for high-yield and investment-grade corporate securities, history also has shown the spread can remain at these levels and even go lower for long periods of time, generating additional value. Moreover, these are the two fixed-income sectors most closely aligned with domestic corporate and economic performance, both of which remain bullish. For similar reasons, commercial mortgage-backed securities (CMBS) also are favored, in part because their performance tends to follow—with a lag—the performance of the economy.
Underweights on mortgages and Treasuries (except short TIPS)
Because of their high sensitivity to rates, we don’t like Treasuries. We still don’t think there’s much opportunity in U.S. agency MBS, either, given the outlook for rising rates and the fact the Fed is still buying up the bulk of mortgage issuance even with tapering. We do see some value in shorter maturity Treasury Inflation-Protected Securities (TIPS), which currently are priced attractively relative to inflation expectations and tend to have less sensitivity to changes in rates.
Taken altogether, the evidence indicates fixed-income investors will have some work to do this year. There’s still value out there, particularly in spread product. But interest-rate risk is beginning to rear its head.