The Wild Ride Of High-Quality Bonds by LPL Financial

Key Takeaways

  • January 2015 was the best month for high-quality bonds since December 2008. In February 2015, high-quality bonds posted their worst monthly performance since June 2013 and the taper tantrum sell-off.
  • High-yield bonds experienced ups and downs thus far in 2015. After a muted January, high-yield bonds returned 2.4% in February, the largest single month gain since October 2013.
  • After a wild first two months, we expect more muted returns over the remainder of 2015.

Hot & cold bonds

The first two months of 2015 have been a case of Dr. Jekyll and Mr. Hyde for bond investors. January was the best month for high-quality bonds, as measured by the Barclays Aggregate Bond Index, since December 2008, with an impressive total return of 2.1%. On the other hand, February erased much of those gains, as high-quality bonds posted their worst monthly performance since the taper tantrum sell-off in June 2013, declining by 0.94%. As of the end of January 2015, the yield on the 10-year had fallen by over 40% over the prior 12 months [Figure 1]. Such an extreme is rare and has happened only two other times during the last 15 years: after the 2008 financial crisis and in 2012 in response the Eurozone crisis.

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Wild Ride

The wild ride of bonds is best illustrated by the 10-year Treasury yield [Figure 2]. When the dust settled, high-quality bonds finished up 1.14% on a year-to-date basis through the end of February, with prices still higher and yields lower for 2015.

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Not Confined to High-Quality Bonds

High-yield bonds experienced ups and downs as well thus far in 2015. After a muted January, high-yield bonds returned 2.4% in February, the largest single month gain since October 2013 (based on the Barclays U.S. High Yield Index).  With oil prices stabilizing in 2015 after the dramatic decline in 2014, dire default predictions receded and yield spreads to comparable Treasuries contracted [Figure 3]. The strength of the energy sector and a relatively good earnings reporting season, which was all but completed by the end of February 2015, helped propel the overall high-yield bond sector higher after a soft start to 2015.

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More to come?

After two big swings, we believe the bond market is on more even footing. The sharp decline in Treasury yields in response to fears over a Greek exit from the Eurozone and overly pessimistic default fears from the high-yield energy sector has largely reversed. Although both of these factors will remain risks for investors in coming months, we believe pricing is more balanced. The risks, which are generally supportive of bond prices, are offset by the likely start of Federal Reserve (Fed) rate hikes later in 2015, and a resilient domestic economy that continues to expand at near 3%.

In the high-yield bond market, we find it unlikely that the sector returns to the highs of June 2014. The low in defaults may be in place, and the uncertainty over high-yield energy defaults could potentially restrain a full improvement back to June 2014 levels. While some modest, further price improvement is possible, interest income, not prices, will potentially be the main driver of return over the remainder of 2015.

SlowDown

A slowdown in bond performance across the board may be the result of a hot and cold bond market [Figure 4]. Even after giving up some gains in February, high-quality bonds are still up a very respectable 1.14% year to date, which mathematically translates to a higher full-year return than we believe is likely. The pace of performance may possibly slow as interest rates gradually rise and prices soften in anticipation of Fed rate hikes and still firm economic growth. The same is true in the high-yield bond market where low yields may translate into mid-single-digit returns with little, if any, boost of additional price appreciation. After a wild first two months, we expect more muted returns over the remainder of 2015.

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