What Did We Learn About Bonds in 2014? by Douglas J. Peebles, AllianceBernstein

After a less-than-stellar 2013 for bonds, many investors were ready to turn their backs on the asset class. But many didn’t—and were rewarded for their long-term perspective.

As we see it, investors can take five lessons from 2014 that also inform how they should pursue fixed-income opportunities in 2015:

1)      Don’t just avoid the crowd—know how to profit from it. Herd mentality is usually a bad idea. As investors crowded into higher-yielding debt last year, many realized too late that they were also increasing portfolio risk. It may have seemed just as straightforward to follow the masses and ditch high yield altogether, but there were other options. Emerging-market debt, for instance, suffered outflows in 2013 but came back into favor in 2014—allowing contrarian investors to profit. As we’ve noted, avoiding crowded trades and their unraveling makes sense for many reasons, and so does thoughtful diversification. But don’t miss out on cheap assets the crowd leaves behind.

2)      Interest rates aren’t your biggest risk. Many investors sold their short- and intermediate-duration bonds in 2014 because they thought rates would rise. In this low-yield environment (especially for short-term bonds), some investors chased riskier products like higher-yielding CCC-rated bonds. These low-credit-quality investments should have set off alarm bells, but, if investors didn’t hear the ring, they took a beating in the second half of 2014. In our view, now isn’t the time to stretch for yield—and investors should avoid CCC-rated bonds because they don’t provide enough compensation for the risk they entail.

  • Extreme rallies happen—and will happen again. Over a two-day stretch in mid-October, investors across the globe rushed to the perceived safety of 10-year US Treasury bonds—yield collapsed by 21 basis points and price soared by nearly 2%. That may be a more severe move than we’ll see in the very near future, but it’s a reminder that liquidity can be challenged even in the most liquid sectors such as US Treasuries. Buying and selling wasn’t the problem—the volume of trades was near record levels. The issue was the severe price movement that volume created. While many investors were surprised, the big price jump lessened the concern. Would they be as complacent if prices fell by 2%? Food for thought.
  • Supply and demand continue to drive pricing. For municipal bonds, it’s been a roller-coaster couple of years. After mutual fund investors pulled out large sums of money and undermined the market in 2013, munis enjoyed a revival in 2014. In fact, they’re back with a vengeance. What changed? First, fear-induced selling caused by Detroit and Puerto Rico headlines subsided. And second, investors became more aware of the broadly improving debt picture for most issuers. Sellers became buyers, stoking demand, and supply was nowhere to be found. We expect this dynamic to continue in 2015, which should help support muni prices going forward.
  • A stronger dollar left many international bond investors unhinged. Concerns over rising rates led many investors to add non-US bonds to their portfolios. But a strengthening US dollar and negative currency impact left some questioning this approach. The Barclays Global Aggregate Bond Index (Unhedged) returned a paltry 0.6% in 2014, compared to an impressive 7.6% for the Barclays Global Aggregate Bond Index (Hedged to USD). The difference is currency hedging: eliminating highly volatile currency exposure from risk-reducing bond portfolios can help weather difficult periods such as 2014, when the US dollar was among the strongest currencies in the world. Currency trends tend to last for a few years, so don’t be surprised if this story repeats itself in 2015.

How did currency-hedged global bond returns compare with returns on US-dollar bonds? The Barclays US Aggregate Bond Index returned 6.0% in 2014. Over time, annualized returns for unhedged global, hedged global and US bonds have been roughly the same, but investing in hedged global has been the least volatile choice with the highest risk-adjusted returns (Display). The bottom line is that investing in currency is risky, and we think core bond investors should consider a hedged global portfolio as their default.

Bonds

What should investors take away from 2014 that can be applied to 2015? When it comes to bonds, the best offense is a good defense—and diversification is critical. Investors should continue to pursue a global, multi-sector approach that’s focused on reducing risk and maximizing opportunities.

This post originally appeared in Institutional Investor. http://www.institutionalinvestor.com/gmtl/3416903/5-Key-Takeaways-from-2014-on-Investing-in-Bonds.html

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income at AllianceBernstein Holding LP (NYSE:AB).