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:
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.
Market Realist – The Industrial Production Index has been gradually improving since Q3 of last year and currently stands at 4.1%. The unemployment rate, on the other hand, is on a downward trajectory. These are clear signs that the economy is improving.
U.S. equity markets (SPY) have taken this outlook as a positive sign. They recently scaled all-time highs. As soon as inflation starts rearing its ugly head, the Fed might hike rates to combat inflation. That won’t be a good sign for either Treasuries (TLT) or corporate bonds (LQD).
You need to be very choosy about bond selection in this kind of scenario. Traditionally, high yield bonds (HYG)(JNK) have benefited from spread compression as the economy improves. But this time around, the uncertainty around monetary policy timing has affected them negatively.
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 (TLT), TIPS (TIP) and municipal bonds (MUB). Also, we have mixed feelings on some areas of the market such as high yield bonds (HYG) and emerging markets debt (EMB), but can certainly identify some select opportunities in these sectors.