Bonds: The 2014 Halftime Report

July 1, 2014 4:10 PM
By Zane Brown

Will the best-performing market segments be able to sustain their momentum in the final six months of the year? 

While the biggest fixed-income story in the first half of 2014 was the drop in 10-year U.S. Treasury yields, from 3.05% to 2.55% ( according to Bloomberg data), tightening credit spreads probably did more to enhance investor returns during that time.  

The drop in Treasury yields helped produce a return on the BofA Merrill Lynch 10-Year U.S. Treasury Yield Index of 6.13%, but few investors keep the bulk of their portfolios in maturities as volatile as the 10-year note. (All index return figures listed in this post are year-to-date through June 30, 2014.)  Instead, the plethora of core, core plus, and total return bond funds suggests that many investors experienced returns closer to 3.93%, which was the return of the Barclays U.S. Aggregate Bond Index, the high-quality benchmark generally used by such funds. 

Investors willing to embrace some credit risk in the form of either lower-quality investment-grade or below-investment-grade securities enjoyed better returns, as the search for yield pushed prices higher and yield spreads relative to Treasuries tighter. The Barclays Corporates Baa Index outperformed even the 10-year Treasury index with a return of 6.81%. The BofA Merrill Lynch U.S. High Yield Master II Constrained Index returned 5.64% for the six-month period.

Yield-hungry investors also pushed up prices of emerging market debt, despite geopolitical concerns and some issues with a slowdown in emerging market growth. The JPMorgan CEMBI Broad Diversified Index logged a return of 6.34%.

It will be difficult for many aspects of fixed income to reproduce these returns in the second half of the year. A dramatic drop in the supply of Treasuries outpaced the tapering of Federal Reserve purchases in the first half. Conditions likely will change in the second half as Treasury issuance increases and Fed purchases under its quantitative easing program likely will end, completely, in October 2014. Stronger gross domestic product growth in the second half could increase inflation concerns and weigh on prices of long-term, high-quality bonds. 

Lower-quality credit seems likely to fare better. Supply appears less likely to increase in the high-yield and leveraged loan segments, for example. In addition, lower-quality bonds are less rate-sensitive and more economically sensitive, allowing them to perform relatively better in a stronger economic environment.  Over the past 20 years or so, Lord Abbett research shows that when yields on 10-year Treasuries have increased 100 basis points or more, yield spreads on high-yield securities have narrowed. This does not necessarily mean price appreciation, just better price performance relative to comparable Treasuries, in addition to higher coupon income. 

Based on expectations for increased Treasury supply, a stable supply of corporate bonds, an improvement in U.S. economic growth, and historical relative performance, credit-sensitive securities seem poised to outperform their high-quality counterparts over the balance of the year.

Zane Brown is a Lord Abbett Partner and Fixed Income Strategist.

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