The days of equity-like returns in fixed income are gone. It has been a storied run. Fueled by monetary accommodation from the Federal Reserve, yields reached new lows in a host of fixed income asset classes as investors were pushed out of the risk curve by historically low Treasury yields. Yields on risky assets are not going to zero, capping future returns with prices at stratospheric levels. Below is a recount of 2012 performance and a discussion of potential returns in traditional fixed income asset classes that can be expected in 2013.
Despite ten-year Treasuries trading in nearly a 100bp range around its miniscule 1.80% average yield in 2012, government bonds finished the year in modestly positive territory. With the front end of the yield curve already anchored by the Fed's commitment to keep short-term interest rates near zero, the price action was in the long end of the curve as the 30-yr Treasury traded in a seventeen percentage point range. Uncertainty emanating from the Eurozone pushed long Treasuries back towards record low yields in the summer, but when it was all said and done, the Barclays U.S. Treasury index (replicated by GOVT) produced a modest positive total return for 2012 of 1.99%.
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Front-end rates will remain anchored in 2013 given the Fed's commitment to keep the Fed Funds rate near zero through mid-2015. There has been a great deal of interest in the long part of the Treasury curve with ETFs providing exposure in unlevered form (TLT,TLO), levered form (UBT) and inverse unlevered (TBF) and inverse levered form (TBT, TMV, TTT). There is far more downside to being long Treasury rates. Remember that for a 9 duration 10-yr Treasury, a 20bp increase in rates will reduce the nominal return on that note to zero given today's low absolute starting yield.
However, taking a bearish position on long bonds is not necessarily a simple trade as the Federal Reserve continues to take duration out of the market with its open-ended purchases of Agency mortgage-backed securities. With monetary accommodation of global central banks leading to very correlated trades in risk markets, Treasuries remain a unique portfolio diversifier, and I do not expect this fact to change materially in the near-term. While I expect the 10 and 30-yr Treasury yield to end 2013 higher than 2012, I think that the increase will be more muted than most prognosticators. As I described the variability of Treasury yields in 2012 above, investors are not getting adequately compensated for this ride even if an eventual material sell-off is not in the cards in 2013.
2012 will be remembered in part for the effect of European sovereign debt markets on global risk markets. While the Europeans stumbled and bumbled their way towards fiscal integration and greater economic harmonization, policymakers ended the year in front of bond bears, which had been pushing yields on topical sovereign debt to unsustainable levels. The best performing sovereign yields on the globe for 2012 were the PIGS countries.
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Expect continued, but lessened, volatility to abound in the Eurozone area in 2013 as the ultimate solution to a unified Eurozone ultimately is measured in decades and not years. If the troika can continue to herd its stray members, the best returns in Europe will again be found out the risk curve as central bank accommodation forces investors into higher risk assets in a similar fashion as has occurred in the United States the last four years.
Investment Grade Corporate Credit
Returns in investment grade corporate credit (see chart below) were aided by compressing credit spreads. Credit spreads tightened across the ratings stack with the lowest-rated BBB bonds ratcheting in the most. Financial sector spreads (14.5% total return) far outpaced industrial and utility spreads (7.4%) as improving bank balance sheets, increased capital ratios, and bondholder-friendly government regulation spurred credit improvement. For example, Bank of America (BAC) has sixty percent of the long-term debt balance that it had just two years ago, roughly a $200 billion reduction. The outperformance of financials is a trend unlikely to abate in 2013, and given paltry yields in investment grade credit, might be the only source of meaningful absolute returns.
High Yield Corporate Credit
Like investment grade corporate credit, returns in high yield corporate credit (above) were directly related to risk with the lowest-rated CCC bonds producing the greatest excess returns. Expect default rates to begin to inch higher from their historically low levels in 2013, and for returns on BB-bonds to keep pace with lower-rated single-B and CCC-rated issues. While there is not much upside in BB-credit, given that the average dollar price is reaching call-constrained levels, investors will begin to price in higher levels of eventual credit losses in more speculative issues.
Total returns for the asset class (JNK) are likely to be only marginally above the current yield to worst of around 6%. High yield should still outperform investment grade credit, so retail investors should see JNK outperform an investment grade bond fund like iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD). I would rather take my exposure out the credit curve into BB-rated bonds than greater interest rate risk by moving out the yield curve in investment grade credit.
Emerging Market Corporate Credit
Emerging market sovereign bonds and corporate credit reached new all-time low yields even in the face of record supply. Dollar denominated emerging market corporate and sovereign debt returned 18% each in 2012. Global investors looked at the emerging economies and saw higher economic growth rates and lower public debt balances, swapping funds from more indebted developed nations. This favorable dynamic led to persistent diversification inflows from global credit investors. This favorable technical backdrop will persist in 2013, and I expect 2013 emerging market corporate bonds to deliver positive excess returns and generate total returns in the 5-7% area as credit spreads continue to compress as global investors reach for yield given abundant liquidity conditions.
Gradually improving commercial and residential mortgage markets, spurred advances in both CMBS and RMBS in 2012 as some of the most reviled securities of the credit crisis posted some of the best returns. Given the absence of meaningful new non-agency mortgage issuance and limited CMBS supply, this has been a market with a very positive technical backdrop. No primary supply, and persistent demand from yield-starved buyers, sent yields to post-crisis lows. While new issuance will rebound in 2013, it will not approach the pre-crisis heights, and seasoned vintage securities will continue to offer outsized carry and generate some of the better returns in the fixed income universe.
Traditionally, I have always thought that buy-and-hold investors can find alpha in the municipal bond market because of the liquidity premium and outsized credit spreads for an asset class that has historically seen very few defaults on its rated debt. On one hand, the story in municipal debt could be like any other high quality, typically long-duration asset class. We will see small credit spread tightening offset by a larger upward move in interest rates, likely producing a total return in 2013 somewhat smaller than the bond's coupon.
On the other hand, I have no idea what will happen in Washington regarding municipal debt's tax exemption. I expect that the tax exemption will reduce over time given it uniquely favors wealthy investors in our progressive tax code, and taxing the wealthy has become an alarmingly populist position. Any change in the tax exemption status could pressure municipals bonds if it leads to an outsized secondary supply without a natural buyer to absorb these bonds. I do not believe that this is a 2013 event, but this open-ended issue will make this asset class increasingly interesting to watch.
For fixed income investors, 2013 will be a pain trade. It will not be the cataclysmic scenario of a sharp upward movement in interest rates that causes large negative total returns across fixed income asset classes for which some bond bears have been waiting. Sharply higher interest rates domestically would derail fledgling progress in housing and mortgage markets and crimp nascent economic growth. The Federal Reserve is committed to not taking away accommodation until the economic recovery is self-sustaining. Instead, this pain trade will be in the form of a grind tighter in credit spreads.
Without a large move in interest rates, bond prices outside of the most overvalued safe haven sovereigns will benefit from narrowing credit spreads, lowering already anemic re-investment rates in spread sectors. This positions the highest beta sectors - speculative grade and emerging market credit - to generate the highest absolute returns in fixed income. Bonds are expensive on an absolute basis and relative to equities. While bonds will deliver very modest positive returns in 2013, the valuation gap will reduce as equities outperform.
Making twelve-month predictions is always an arduous chore because new information will be received throughout the year and changes the bounds for what is possible. Fiscal missteps in Congress, elections in Europe that could upset the fragile political balance, geopolitical risk in the Middle East and notably Iran, and even the potential for social unrest in China given the growing gulf between rich and poor in that economic giant all bear watching.
This article is my base case for 2013 - credit spreads move tighter across asset classes, despite minor pockets of volatility, and Treasury yields move modestly higher in the long end of the curve. Best of luck for a prosperous New Year.