Fixed Income: Options for a Low Rate World
Source: Credit Suisse Leveraged Loan Index, Barclays, as of 11/22/13. Past performance does not guarantee future results. Senior Loans are represented by Credit Suisse Leveraged Loan Index, definitions of index and duration are stated at the end of the piece.
- Outlook 2014
- U.S. and Europe: Slow and Steady
- China: Consumers Keep Spending
- Fixed Income: Options for a Low Rate World
- U.S. Energy: Game-Changing Growth
View 2014 Market Outlook
- It looks like another year of modest growth for developed and emerging market fixed income investors.
- The U.S. economy probably won’t meet the Fed’s employment and inflation targets.
- We believe senior loans and municipal bonds are some of the best fixed income options.
2014 looks to be another year of modest growth in both the developed and emerging worlds, accompanied, for the most part, by subdued inflation. Such an environment should keep interest rates in many areas low, making it more challenging for fixed income investors to find attractive real (net of inflation) yields.
A U.S. rate hike in 2014 is unlikely, given that the U.S. economy may not reach the Federal Reserve's employment and inflation targets of 6.5% and 2.5%, respectively, for at least a few years. While the Fed's efforts to taper its large scale asset purchases may temporarily push bond yields higher (and, as a consequence, prices lower), treasury rates are unlikely to climb much higher than 3%; a self-correcting mechanism likely comes into play above such levels. Elsewhere in the developed world, central banks are also likely to keep rates low.
In this "low rates for a long time" world, we believe a carry-driven strategy is the best option. That involves underweighting treasuries and overweighting credit, such as senior bank loans.
Senior loans currently offer highly competitive real (after inflation) yields, provide a natural hedge against rising rates, are usually collateralized, and are higher in the corporate structure than many other bonds. Yes, these loans are potentially prone to greater default risk than higherquality fixed income investments. However, corporate balance sheets are healthy enough to make large-scale defaults unlikely. Senior loans' yield spreads to treasuries have narrowed from their post-crisis peaks but have yet to return to "fully valued" levels.
International bonds, including emerging market debt, also offer areas of opportunity heading into 2014, with real yields well above those of the Barclay's U.S. Aggregate Bond Index in many cases. Though emerging market debt took a hit during last summer's "taper tantrum," many economies sport solid debt-to-GDP ratios and credible central banks.
Source: Merrill Lynch BBB Municipal Index, as of 11/22/13. Past performance does not guarantee future results. Municipal bonds are represented by the Merrill Lynch BBB Municipal Index, definition is stated at the end of the piece.
Taxable equivalent yield is based on the standardized yield and the combined effective federal and state tax rate of 43.4% for 2013 and assumes that alternative minimum tax (AMT) does not apply.
For investors seeking tax-advantaged income, municipal bonds enter 2014 truly cheap given their credit profiles. The Merrill Lynch BBB Municipal Master Index offers a taxable equivalent yield of 10.2% as of November 22, 2013. Rate fears and headline-grabbing events in 2013, such as the Detroit bankruptcy and concerns over Puerto Rico hurt prices across the asset class, but Detroit represents an exceptional case among municipalities, and Puerto Rico continues to take steps to strengthen its finances. By and large, improving state and local finances mean default rates should remain exceedingly low--much lower than among similarly rated corporate bonds, for example.
While benchmark interest rates in the U.S. are unlikely to spike in 2014, investors must appreciate that the risk of a rate back-up does exist. To seek protection against the effect of rising rates, investors should remain mindful of duration (interest rate risk) and keep maturities short.
Source: Moody's Investor Services. Data regarding default rates is from a study titled "U.S. Municipal Bond Defaults and Recoveries, 1970-2012," dated May 7, 2013. The study is conducted annually and this is the latest data available. The above figures provide cumulative default rates for Moody's-rated Corporate and Municipal debt rated Baa. For example, obligations in the Baa Municipal category had a default rate of 0.01% within one year of the initial rating, 0.03% within two years, etc.
*Moody's Baa is equivalent to Standard & Poor's rating of BBB. Baa/BBB is a medium-quality, investment-grade bond rating assigned to a corporation based on the issuer's ability to pay interest and repay principal upon maturity. Past performance does not guarantee future results.
The Credit Suisse Leveraged Loan Index tracks the performance of senior loans. The Barclays U.S. Aggregate Bond Index is an investment-grade domestic bond index. The Merrill Lynch BBB Municipal Index measures the performance of U.S. tax-exempt bonds rated BBB. Each index is unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any fund. *Past performance does not guarantee future results.*
Duration is a weighted average term to maturity of the security's cash flows expressed in years. Duration helps measure a security's and portfolio's price sensitivity to changes in interest rates.
Fixed income investing entails credit risks and interest rate risks. When interest rates rise, bond prices generally fall, and a fund's share prices can fall. A portion of municipal bond fund distributions may be subject to tax and may increase taxes for investors subject to Alternative Minimum Tax (AMT). Capital gains distributions are taxable as capital gains. Senior loans are typically lower-rated and may be illiquid investments (which may not have a ready market).
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