Asset Allocation – Where Does Fixed Income Fit It? by Columbia Management

  • Surprisingly solid returns for bonds in the first half could lead to disappointment in the second half of the year.
  • We continue to believe high-yield bonds are worth holding, especially higher quality ones.
  • Improved country fundamentals and strong technical support favor EM bonds but caution that returns could be less stable in the near term.

So far this year, returns on bonds are positive, with longer duration U.S. bonds performing even better than equities. Negative sentiment on bonds had been building in concert with expectations of improved growth and higher rates. Instead, growth disappointed and rates fell, providing the catalyst for solid returns from bonds in the first half. At current levels we once again expect bonds to deliver negative or relatively low returns unless growth disappoints in the second half.

U.S. rates may appear low in absolute terms, but compared with the rest of the developed world, they are actually higher in a relative sense than at any previous point in this cycle (Exhibit 1). The spread between the 10-year U.S. Treasury and the simple average of G7 bonds of similar maturity is 63 basis points. Returns for developed bond markets outside of the United States were generally even better than returns for U.S. Treasuries so far this year. The lower rates elsewhere make sense in the context of weaker economic performance, but the prospective returns for government bonds across the globe are now paltry.

Exhibit 1: U.S. bond yields relative to G7 bond yields of similar maturity

Asset allocation Bond Yields

As of June 30, 2014

We remain overweight in high-yield bonds but valuation analysis suggests that returns are likely to be modest going forward, driven primarily by coupon income rather than further spread tightening. Spreads on high-yield bonds are approaching historical lows, but strong corporate fundamentals, favorable financial conditions and technical factors such as high demand for higher yields are supportive of the asset class. Yields on lower rated bonds, such as CCC, are poor and do not compensate for the potentially higher probability of default on such debt. We continue to recommend owning high-yield bonds with an emphasis on better quality within high yield.

Several factors were supportive of emerging market bonds this year. The post taper tantrum spread widening last year had built up sufficient valuation support to make these bonds attractive. In addition, Emerging Market (EM) country balance sheets continued to improve in the first half, particularly for the fragile five economies, providing fundamental support to EM bonds. We continue to recommend EM bonds on improved country fundamentals and strong technical support but caution that returns could be less stable in the near term as the countries adjust to changes in the Federal Reserve’s monetary policy stance.

To read our full outlook please read our Investment Strategy Outlook