About a month ago, I wrote a post advising investors to rethink their approach to traditional bonds in 2014. With the New Year now underway, it’s a good time to take a deeper dive into fixed income markets to consider where (and how) to find opportunities.
As I’ve done for the past couple of years, I’ve framed my 2014 Fixed Income Outlook around “My Favorite Themes” that cover my views of the economy, the Fed and where investors may find value (and what they should avoid).
You can access the full report here. In that piece, I outline six major themes that will shape the bond markets in the coming year, but below is a quick recap of the three most important—along with thoughts for how to position portfolios:
- Theme One: How I Stopped Worrying and Learned to Love the Bond.
We do love bonds in 2014, but that love is conditional. We’re expecting a 50-basis-point increase in the 10-year Treasury in 2014 (relatively modest by the standards of 2013). We also believe we will see a greater rates increase in short-duration areas of the market. The implication? Owning longer-maturity bonds while selling shorter maturities could be a winning combination in the year ahead. We also think that in an environment of rising rates, staying flexible is key.
- Theme Two: Shorten Your Duration, but Don’t Own Short Duration.Related to our first theme, we think the most vulnerable area of the bond market is the two- to five-year maturity range. Longer-maturity bonds look more attractive than they used to given the rise in rates we saw last year and the Fed should keep rates in the ultra-short end of the curve static. It’s that area in the middle that looks dicey. This means that investors should underweight short-duration strategies as well as bank loans, one of the darlings of 2013.
- Theme Three: Balancing Credit and Interest Rate Risk.Today, the marketplace is pricing in the risk of rising interest rates, but is all but ignoring credit risk. Given that interest rates have been climbing and credit spreads have been narrowing, some credit sectors are starting to look more vulnerable. For now, we still like the high yield sector given that liquidity is high and defaults are low, but this is an area that bears watching. We also like securitized assets for their income-generation potential, but note that price risk is to the downside. We have a less favorable view toward investment-grade credit (tight spreads and expensive valuations) as well as toward bank loans (tight spreads and potentially misunderstood interest rate and liquidity risks). In contrast to last year’s views, we’ve upgraded agency mortgages to start the year neutral (reasonable valuations and improving spreads).
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able tomake principal and interest payments.