Clark: Credit Trumps Duration In Bonds

February 11, 2014

Despite taper-related yield jitters, a number of bond ETFs stand out from the crowd.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features K. Sean Clark, CFA, chief investment officer of Philadelphia-based Clark Capital Management.

In 2013, the markets were fueled by Fed-driven liquidity and an improving economic landscape both in the U.S. and overseas. All those factors helped spur global equity markets higher.

It was a different story for fixed income, with most fixed-income sectors losing ground as concerns about Fed tapering of quantitative easing and stronger economic growth drove interest rates higher.

Fixed income suffered losses, with the Barclays Aggregate Bond Index down 2.02 percent. It was the biggest yearly loss for the bond market since 1994. Treasurys posted losses across the yield curve, with the Barclays 7-10 Year Treasury Index down 6.04 percent and the Barclays 20+ Year Treasury Index down 13.88 percent.

The bright spot in the fixed-income asset class was below-investment-grade credit, with the Barclays High Yield Index posting a 7.44 percent gain. That’s part of the reason we favor high-yield ETFs, such as the iShares iBoxx High Yield (HYG | B-75), the SPDR Barclays High Yield (JNK | B-61) and even the fundamentally weighted PowerShares Fundamental High Yield (PHB | B-74).

But before getting into that too much, let’s talk about some of the other head winds facing fixed income in 2013 besides Fed tapering.

The U.S. economy gained momentum throughout the year. The improving economic outlook and strong equity market gains led investors to pull assets from bonds and rotate into equities.

According to the Investment Company Institute (ICI), retail investors sold bond mutual fund holdings for eight-consecutive months through December. In December alone, U.S.-focused bond funds suffered outflows of $22.3 billion. Given the massive performance differential between stocks and bonds in 2013, we believe a good case can be made that we could see reallocation back into bonds and out of stocks in early 2014.

Fund flows data from ICI shows very little evidence of a meaningful rebalancing from the public in January, though data compiled by ETF.com is indeed showing clear evidence of a move back into bonds.

The Fed has finally embarked on tapering, and we expect the central bank will continue to cut back on its asset purchases by $10 billion at every meeting, unless there is a notable change in its economic outlook.

Recent comments from Philadelphia Fed President Plosser suggest he wants to taper even faster. In a recent interview, he said: “My preference is to scale back our purchase program at an even faster pace to reflect the strengthening economy.”

Before tapering began, the Fed was buying about 75 percent of the Treasurys in the market, and as a massive buyer, it has been able to keep rates low. But even with that massive buying power, rates have doubled over the last year. As the Fed leaves the market, the stage is set for a disruption in the markets as the absence of such a major buyer ripples through the market.

The yield on the 10-year Treasury note rose from a low of 1.4 percent in July 2012 to as high OF 3.03 percent at the very end of 2013.

But as we turned the page from 2013 to 2014, there appears to have been a change of sentiment toward bonds. We are hesitant to call it a sea change, but the tide of higher rates has temporarily stopped flowing. Yields on benchmark 10-year Treasurys seem for now to be stuck in a trading range between 2.5-3.0 percent over the past five months.

The 10-year yield has fallen to the low end of the range and touched 2.59 percent in tandem with a little correction in the stock market. Will this reprieve from higher rates last? We think rates will eventually break out of the range to the upside in the second half of the year, and may challenge 3.50 percent before the year is over.

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