It’s been a tough road for bond investors over the past year. After a long period of time during which interest rates were falling or were relatively stable, we finally saw a long-awaited spike in rates in the middle of last year, with higher overall volatility levels in bond markets than many are used to (as a reminder, when rates rise, the prices of bonds falls).
The start of 2014 has continued this pattern of volatile activity—rates are actually lower today than they were at the start of the year and the outlook for bonds remains uncertain. So what should investors expect from here? And how can they position their portfolios?
Forecasting is always a tricky business, but we do believe there are some important factors that will shape the future direction of the bond market and that will have an impact on the way investors should approach fixed income:
1. Interest rates should move higher over the coming year: We would attribute the drop in rates that occurred in early 2014 to a combination of investor risk aversion sparked by problems in emerging markets and weakness in economic data, exacerbated in part by weather disruptions. These are probably short-term factors that are unlikely to persist. In our view, a combination of better-than-expected economic growth and Federal Reserve QE tapering will push rates modestly higher—and investing in a rising-rates environment can be challenging.
2. Rates at the “belly” of the yield curve will rise more dramatically than long-term rates: This might seem counter intuitive since shorter-term rates are generally less sensitive to rising rates (lower duration = lower rate sensitivity), but we expect the yield curve to flatten and for rates at the belly of the curve (3 to 7 year segment) to rise more dramatically, and remain more volatile, than long-term rates—bad news for shorter-duration assets, and an argument for maintaining flexibility in bond duration positioning.
3. Volatility among and within fixed income sectors should be high: Given all of the changes happening, we believe this is the sort of environment where we’ll see area of the market quickly move in and out of favor. Right now, we generally have an unfavorable view toward Treasuries, but do like long-duration Treasuries, TIPS and municipal bonds. Also, we have mixed feelings on some areas of the market such as high yield bonds and emerging markets debt, but can certainly identify some select opportunities in these sectors.
The bottom line is that we think a traditional approach to fixed income investing will struggle. Investments that track or mirror broad market indices such as the Barclay’s U.S. Aggregate Bond Index are overly concentrated in government-related debt (which will suffer if rates rise) and don’t have sufficient flexibility to adapt as market conditions change.