Bond market outlook: interest rates a determining factor

Lisa Black, Head of Global Public Fixed-Income Markets

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Since the start of the financial crisis in 2008, the United States and other nations have promoted policies intended to push interest rates lower to stimulate their economies. In turn, lower interest rates have driven bond prices higher and generated strong returns for some investments in fixed income instruments. We believe that investors with exposure to bonds of any kind need to stay focused on economic developments, such as interest rates, and understand how these developments can impact their portfolios.

Winners and losers
The principal segment of the bond market benefiting from lower interest rates has been medium- and long-term U.S. Treasuries and inflation-linked bonds. In addition highly rated corporate bonds have held their own in this low interest-rate environment.

On the flip side, short-term fixed-income investments — often purchased by money market funds — were negatively impacted by lower interest rates. In addition, high-yield corporate bonds and emerging market bonds underperformed U.S. Treasuries until the fourth quarter of 2011. While the short-term interest rate environment is unlikely to change this year, we believe that other factors, such as the more encouraging U.S. economic outlook, will benefit high-yield corporate and emerging market bonds this year.

Flight to safety
Sluggish economic growth in the U.S., coupled with Europe’s sovereign debt crisis, has driven many investors to seek out the safety, stability and steady returns offered by U.S. Treasuries and, to a lesser extent, highly rated corporate bonds. These strong elements of the bond market are illustrated by the performance of the Barclays U.S. Aggregate bond index, which includes a mix of government and corporate bonds, since the onset of the global financial crisis. The index rose 7.84% last year — its best performance since 2002 — and also turned in solid returns in 2010 (6.54%) and 2009 (5.93%), when interest rates were low.

But consider these factors
In 2012, a number of interrelated factors will influence the direction of the bond market. One is the Federal Reserve’s recent announcement that it will keep short-term interest rates at “exceptionally low levels” at least through late 2014. By doing so, the Fed hopes to spur borrowing and stimulate the economy. In the meantime, however, it all but ensures that returns in money market funds and short-term bonds will remain at, or near, zero. Given the continuing slow recovery from the Great Recession, including high unemployment and a very weak housing market, we believe that these conditions are unlikely to change anytime soon.

Another key factor influencing the performance of the bond market in 2012 is inflation. Last year, fears of inflation, coupled with the Federal Reserve’s so-called “Operation Twist” initiative (buying long-term bonds, to help reduce long-term interest rates) helped trigger large gains among inflation-linked bonds. Accordingly, the Barclays U.S. Government Inflation-Linked Bond Index rose 13.56% in 2011. The Fed’s recent announcement of a formal target for the U.S. inflation rate of 2% reflects its belief that inflation is not a major concern and the economy is not at risk of overheating. As a result, we anticipate smaller gains among inflation-linked bonds. In contrast, nominal bonds are likely to be bolstered by lower inflation expectations, since unexpected inflation won’t eat into real bond returns. (Nominal Treasury securities provide “before-inflation” returns.)

Most important for the bond market is the direction of the U.S. economy and the sovereign debt crisis in Europe. Continued improvement in the U.S. economic growth numbers will put modest upward pressure on longer-term interest rates, as investors exhibit greater tolerance for risk. The hunt for yield was underway in the fourth quarter last year, with a high yield bond index generating a 6.46% return — higher than any other fixed income class. Conversely, the turbulence in Europe curbed some risk-taking, which depressed returns among eurozone government bonds, which fell 3.73% in the fourth quarter. While these bonds are attractively priced, the continued uncertainty in Europe could continue to put a damper on performance.

Bottom line for investors
For investors, a strengthening U.S. economy could translate to strong performance among bonds linked to sectors benefiting from higher consumer demand for energy and other commodities. Energy and commodity producers experienced a roller coaster ride in 2011, but rising demand and supply concerns should bolster energy prices and investors’ perceptions of the ability of these producers to pay back debt. We expect the high-yield bond market to build on its fourth quarter performance as investors become more confident about the economic outlook. More generally, corporate bonds tend to perform well in periods of stronger economic growth, as there is more tolerance for risk and the higher returns that compensate for that risk.