Six Lessons We Learned About Bonds in 2015

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In 2015, bond investors faced slower nominal global growth, less liquid markets and a looming US rate hike. But with challenges come lessons: here are some takeaways from 2015 that should remain important in 2016.

1) The Fed tightened without raising official rates. It pulled this off mostly by winding down asset purchases. That means that when a quarter-point hike in the federal funds rate comes, it won’t be the first time the Fed will have tightened policy. The market spent the past 12–18 months adjusting to tighter conditions through a stronger US dollar and periodic sell-offs across bonds, stocks and commodities.

Things could get trickier in 2016 as the Fed’s balance sheet starts to shrink and rates creep higher. That will drain dollars from the global financial system—call it a decline in dollar liquidity—and it could pressure those who need dollars most, such as emerging-market borrowers. It could also be tough on asset prices and trading liquidity, which brings us to our second lesson.

2) Low liquidity is the new reality for bond investors. Fixed-income trading liquidity issues have been around since the global financial crisis. But most investors didn’t start paying much attention to them until this year. Expect these issues to stay front and center in 2016. And if Fed tightening keeps draining US dollar liquidity, trading liquidity may dry up further, making it even harder to trade bonds without having a big effect on their prices. Of course, investors who manage liquidity risk well may be able to profit. Having a manager who understands this will be critical.

3) The US economy has turned a corner. But will markets stay on track? After the global financial crisis, US banks spent years licking their wounds and refusing to lend. That’s changed recently, and the economy has shifted into a higher gear, paving the way for Fed rate hikes. But will global financial markets run into a rough patch if the Fed keeps tightening policy throughout 2016? Hard to say, but it’s definitely worth keeping an eye on.

4) China is successfully rebalancing. Sure, the Chinese economy is slowing, but it’s also evolving from an export-oriented economy to one in which consumption and services play a bigger role. A lot of observers have overlooked this, possibly because many Western companies are exposed to China’s heavy industry sector, which has struggled. Meanwhile, the renminbi’s new status as an IMF-designated elite reserve currency will augment China’s growing presence in global bond indices and draw a lot of investment dollars into China. We think there’s a good chance that China will experience a cyclical upswing next year.

5) If you’re investing in high yield, avoid passive ETFs. Investors rushed into high-yield exchange-traded funds (ETFs) this year. They may come to regret that haste. High-yield ETFs have a terrible track record and haveunderperformed most actively managed funds over the long run.

High yield has offered equity-like returns, with less volatility over time, and it isn’t highly correlated with interest rates. But the market is complex, relatively illiquid and hard to navigate, which gives skilled asset managers an advantage over index-tracking ETFs. Sure, ETFs can be useful for short-term tactical trades. But if you want to invest in high yield, ETFs are the wrong way to go.

6) When building a bond portfolio, go beyond your backyard. Investors tend to prefer home-country bonds. But global bonds—provided they’re hedged to the investor’s home currency—have delivered returns comparable to domestic bonds, with lower volatility. And global bonds help diversify interest-rate and economic risk, which is important now because monetary and economic policies are diverging. The Fed is on the verge of tightening policy, while Japan is holding steady and the euro zone is in highly stimulatory mode.

Navigating the bond market won’t be easy in 2016. That doesn’t mean investors should turn their backs on bonds. Instead, make sure your bonds are global, diversified and with a manager that has the flexibility to reduce risk without sacrificing opportunity.

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

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