Slowing Market Momentum Hurts Bonds by LPL Financial

The third quarter of 2014 may serve as a blueprint for what investors can expect over the fourth quarter. Bond performance slowed markedly after a strong first half of 2014, with the broad Barclays Aggregate Bond Index returning a scant 0.2% for the third quarter. Year-to-date bond performance is still firmly positive but has not materially improved since May 2014, and the three-month rolling return has decelerated reflecting the slower pace of returns [Figure 1]. As we highlighted in our Mid-Year Outlook: The Investor’s Almanac, we believed bond performance would be roughly flat over the remainder of the year after a strong first half and we expect that trend to continue.

Bonds

Winners and Losers

As is typically the case, winners and losers were present despite the flat overall return in the high-quality bond market. Longer-term bonds outperformed within the bond market as geopolitical risks led to price gains in early August and again over the latter half of September. But here too performance slowed as the Barclays U.S. Long Government/Credit Bond Index increased 1.0% over the third quarter — a sharp slowdown after the first two quarters of the year saw returns of 6.6% and 4.9%, respectively.

Bonds

A 1.0% gain does still show the power of bonds to provide diversification benefits during volatile periods, but stronger economic data in recent months have limited the lift geopolitical risks provide to bond prices.

Municipal bonds were one of the beneficiaries of long-term bond strength during the third quarter. On average the widely followed municipal bond indexes are generally longer maturity, including the Municipal Bond High Yield Index. The Municipal Bond High Yield Index was boosted by a rebound in Puerto Rican debt as most high-yield municipal bonds saw lesser gains. Despite modest weakness in September, a scarcity of supply continues to support municipal bonds.

At the other end of the maturity spectrum, short to intermediate bond prices were unchanged to slightly weaker. Most short-term bond prices declined and yields increased over the third quarter of 2014, a trend that has been in place for much of the year, as this portion of the market braces for an eventual Federal Reserve (Fed) interest rate increase in mid-2015.

Segments of the market, such as Treasury Inflation-Protected Securities(TIPS), high-yield bonds, bank loans, and emerging market debt (EMD), experienced outright declines [Figure 2]. TIPS suffered from declining inflation expectations as inflation measures decelerated and the Fed reiterated that inflation remains too low, while a poor September and a slew of negative news headlines hurt high-yield bonds, bank loans, and EMD.

Fourth Quarter Outlook

As we begin the fourth quarter of 2014, a challenging environment will likely persist over the remainder of the year and perhaps beyond. Valuations across many bond sectors remain above historical averages and reflect an expensive market. Bonds may remain expensive but high valuations will likely still limit opportunities for investors and perpetuate a low-return environment.

Additionally, yields are near year-to-date lows and have priced in a lot of favorable news. Specifically, bond futures continue to reflect a first Fed interest rate hike during the summer of 2015, but a much more gradual pace of rate increases thereafter. Bond futures differ sharply from Fed forecasts. Although the Fed may in fact take longer to raise rates, that expectation was already prevalent throughout the third quarter. An additional catalyst would be needed to drive bond prices materially higher beyond the flattish 0.2% return of the third quarter.

So what is needed to drive bond prices materially higher? One, or a combination, of the following would likely be needed to spur additional gains:

  • Signs of an economic downturn or recession. Most economic indicators continue to suggest the opposite—an expanding economy. Last Friday’s stronger than expected monthly jobs report pressured bond yields after geopolitical concerns drove prices higher early in the week. Employment data were the latest sign that fundamental conditions continue to reflect an economy that is growing at around a 3% pace. §§ Bond-friendly change in Fed policy. The Fed remains on track to raise rates in summer 2015, but an indication that the Fed may push back the start of rate hikes may spur additional price gains as it delays a source of risk for the bond market.
  • Drop in domestic inflation. Domestic inflation as measured by the Consumer Price Index (CPI) has decelerated after a spring increase. Deflation remains a risk in Europe and the recent strength of the U.S. dollar may also keep inflation low. As long as the economic expansion remains on track, and Fed policy accommodative, we believe the low in inflation was made early in 2014 and is unlikely to be revisited. Beyond the factors above, a major geopolitical event with significant international repercussions could also drive bond prices higher. Such a move may be very short lived, however, and dependent on the extent of any economic disruption. Historically, geopolitical impacts have been short lived.

Corporate Opportunity

Some of September’s laggards may provide the best opportunity in this challenging environment. A series of events has conspired against high-yield bonds (see the September 30, 2014, Bond Market Perspectives, “Late Summer Setback”). Most of them have been geopolitical, with airstrikes in Syria, protests in Hong Kong, conflict in Gaza, and renewed tensions in Russia-Ukraine sparking fears along with bad economic data in Europe. But in the United States the low default environment persists and the upcoming earnings season may continue to show that corporate credit quality remains strong, further bolstering the case for corporate bonds over the fourth quarter (please also see the October 6, 2014, Weekly Market Commentary, “Earnings Preview: Welcomed Opportunity to Focus on the Micro”). We believe these sectors allow investors the best defense in what will likely be a continuation of the low-return environment for fixed income.