The prospect of a strong economy in the United States and a strengthening one in much of the rest of the world is good news for workers and for many companies. But for bond investors, it is a headache. “We're not of the view that there is any sector ...
What’s worse, if the economy remains strong, there is a good chance that yields will move higher. That is a problem for fixed-income investors because rising bond yields mean falling bond prices. For people holding bond mutual funds and exchange-traded funds, total return is a combination of yield and price. It all makes it less likely that core bond funds — those that focus on high-quality securities — will be able to match the 3.7 percent average gain for 2017, which was 1.5 percentage points ahead of the inflation rate.
“We are in a transition market,” Mr. Bhatia said.
As evidence, consider that the difference between short and long-term rates is less than it has been since 2007. In bond market parlance, the yield curve has flattened.
Why has this happened? Shorter rates are being pulled upward by the Federal Reserve from the near-zero level that the Fed instituted during the financial crisis.
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Longer term rates, on the other hand, are constrained by the expectation that inflation will remain very low in 2018.
Rick Rieder, global chief investment officer of Fixed Income at BlackRock, says inflation could surprise the market next year. It is possible that a falling unemployment rate at a time of solid economic growth could put ample pressure on wages that would, in turn, raise inflation off the floor. “I think we can get to 2 percent,” Mr. Rieder said. The Federal Reserve’s preferred inflation measure has crawled along below 1.5 percent since the financial crisis.
A 2 percent inflation rate would most likely just nudge long-term rates higher, he said, adding that he expects a “slow and low trajectory” for long-term rates. His base case is that the 10-year Treasury rate, now at about 2.5 percent, won’t rise much beyond 2.7 percent.
Unless inflation surges unexpectedly, a 3 percent yield for the 10-year Treasury note may not be likely. Julien Scholnick, a fixed income manager at Western Asset Management, which manages $435 billion in global bond portfolios, notes that a year ago, the 10-year Treasury bill rose briefly to 2.6 percent. And that was after the surprise election of Donald J. Trump spurred an expectation of quick stimulus materializing through tax changes, infrastructure spending and regulatory easing.
“We don’t see higher inflation as probable,” in 2018, Mr. Scholnick said. With an expectation that long-term rates will not venture far from current levels, the Western Asset Core Plus Bond fund currently has an average duration — a measure of risk to changing interest rates — that is slightly higher than the six-year norm for the benchmark Bloomberg Barclays U.S. Aggregate Bond index.
Shifting economic and market dynamics in 2018 may raise the value of small tweaks to basic bond portfolios.
The high-quality United States bonds in the aggregate bond index will deliver on their main purpose in your 401(k): When stocks falter, these bonds will hold their ground, and they may even rally. But the aggregate index will also be very sensitive to Federal Reserve interest rate increases, as 37 percent of the index is invested in Treasuries and another 27 percent in government agency bonds.
Mr. Bhatia at Neuberger Berman recommends adding high-quality corporate bonds, which will not be as sensitive to rising rates as government bonds. The flattening yield curve makes short-term issues attractive; you get a solid yield without the higher volatility of a fund invested in longer-term bonds. The 2.5 percent recent yield for the Vanguard Short-Term Corporate Bond Index fund is about half a percentage point more than the yield for comparable short-term Treasuries.
With inflation low and the economy strong, economy, the profitabilty of investing in bonds is not expected to increase anytime soon. Credit Victor R. Caivano/Associated PressThe recently enacted tax package could also be a moderate benefit for corporate bonds. With a lower corporate tax rate, businesses are expected to bring more foreign earnings home, increasing the cash available to pay for dividends and share repurchases. That could mean the supply of new corporate bonds will shrink a bit, as companies lose some appetite for issuing debt to bolster shareholder returns.
Basic math suggests that there is less reason to invest in lower quality corporate bonds. Kathy A. Jones, chief fixed income strategist at Charles Schwab, points out that high-yield bonds pay about 3.4 percentage points more than similar maturity Treasury issues, in contrast to the 5.4-percentage-point spread investors have typically been paid for taking on the risk of junk bonds. That’s not much compensation, given that junk bonds tend to behave a lot like stock in bad markets.
Investors who enjoyed the strong 6 percent return for multisector bond funds in 2017 should take note that on average, more than one-third of the assets of these go-anywhere bond funds is invested in junk bonds, according to Morningstar.
Mr. Scholnick says Western Asset Management has reduced its high-yield holdings and increased its investment in bank loans. These securities are a form of low-quality corporate bonds with two compelling value propositions over standard junk bonds. In the event of a default, bank loan investors are paid before regular bond investors. In addition, the interest rate on bank loans fluctuates along with a benchmark index, such as the London Interbank Offer Rate, or Libor, and prospects for an increase are viewed as good.
Emerging market bonds may be the best relative value for bond investors these days, considering that in many countries, economies are growing, inflation is low and central bank policy is reasonably strong.
“In the past, it was emerging markets that held all the debt, but now all the debt is in Japan, Europe and the U.S.,” said Mr. Rieder of BlackRock. In 2018, the best opportunities for positive returns after accounting for inflation could be in emerging markets.
Emerging markets also are often more volatile. So for less adventuresome investors, money market funds may be appealing. The Federal Reserve’s rate increases are slowly pushing these yields off zero. Mr. Bhatia says such funds will probably pay 1.5 to 2 percent by the end of this year.
Even if the returns in money market funds are low, you are paid something to park your money on the sidelines while waiting for sell-offs in bonds and stocks to present better prices to reinvest.
“Suddenly, it’s an asset class to consider,” he said.
Credit and Debt,Stocks and Bonds,Inflation (Economics),Interest Rates