Time To Stay Tactical In Fixed Income

March 02, 2015

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 is by K. Sean Clark, chief investment officer of Philadelphia-based Clark Capital Management.


The high-yield market was bloodied in the second half of last year, primarily due to the collapse in energy prices. While yields and spreads backed up, broader-based credit remained firm, suggesting that it was an isolated problem related to rapidly expanding oil and gas production in the U.S.


We think there will be bouts of high volatility this year in fixed income and that liquidity could be key to the direction of bonds in 2015. Given concerns about heightened volatility and the historical direction of the return stream just prior to the first rate hike, we think it's necessary for investors to remain flexible and adopt a tactical approach that seeks to capitalize on total return potential while minimizing risks.


We also anticipate a re-emergence of opportunities in the high-yield space in 2015 as well as heightened risk in Treasurys.


And we're not the only ones who feel that way:


Byron Wien, Vice Chairman of Blackstone Advisory Partners, issued his list of Ten Surprises for 2015. In it, he mentions that he expects a very good year for high-yield bonds: "The year-end 2014 meltdown in the high-yield market, as a result of the collapse in the price of oil, creates a huge buying opportunity. The spread between high yield and Treasurys is cut in half, and high yield becomes the best performer of the various asset classes as the U.S. economy continues to grow with no recession in sight."


Nobel Laureate Professor Robert Shiller recently told CNBC: "We can't go below zero, not far below zero. It seems to me this 'new normal' culture could last, but then it could crash . . . I think it's a risky time to be investing in long-term fixed income."


Still, that doesn't mean that a crash in bond prices is around the corner. "Yields have been trending down since 1981, over 30 years now," Shiller added in an email to CNBC on Thursday. "There could be a major turning point again in coming years, but I see no reason to think that such is imminent."


Billionaire Investor Warren Buffett flatly told FOX Business Network in his first major interview of 2015 that "the last thing" he would want to buy right now is a 30-year government bond. When asked about a 10-year Treasury Buffett quipped, "I don't want a 10-day bond."


2015: A Different Bond Market Than 2014's

We expect the U.S. economy to expand 3.0 percent in 2015, and with the unemployment rate possibly approaching full employment, we see no reason for the Federal Reserve to keep interest rates at zero. Given the improving U.S. economic conditions, the Fed is expected to begin hiking rates in the second half of the year, in all likelihood beginning in June.


The entire yield curve has flattened and we expect that to continue into 2015 as the Fed hikes short-term rates, and falling energy prices and inflation expectations keep a lid on long-term rates.


This year's fixed-income markets are likely to perform differently than they did last year.


With much of the developed world's sovereign bonds now trading at negative interest rates, gains should be limited. U.S. Treasurys could be the exception with high demand for U.S. sovereign debt given the strong dollar and yield premium compared with other government debt.


However, we sense it unlikely that Treasurys will serve up the big gains again this year as the Federal Reserve seems ready to lift interest rates in the second half of the year.


A Historical Perspective: Bond Sector Performance Before & After Fed Rate Hikes

Since 1980, the Fed has embarked on a new rate hike cycle seven times.


The table below from Ned Davis Research summarizes bond sector performance around the first Fed rate hikes since 1980. From the data, it's clear that bonds historically tend to underperform and outright decline, leading up to the first rate hike, but then they typically advance following the hike.


In the past, the clear winners around the first rate hike were high yield and emerging market debt, which was likely due to their lower correlation to Treasurys and leverage to the economic cycle. High-yield and emerging-market debt have posted only modest median losses three months prior to the rate hike and have posted the strongest gains six, nine and 12 months later following the rate hike.




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