The Fixed Income Landscape: What A Difference A Year Makes

by: Matt Tucker, CFA

As we are one third of the way into 2014, I think now’s a great time to check the fixed income returns score board and see how different segments of the market have performed so far. If you recall, as we entered the year there was broad consensus that we would see gradually rising interest rates throughout the year, and investors were unsure of how to play the fixed income market. The 10 year Treasury opened the year at 3.02% and was expected to climb into the 3.25-3.5% range by year-end. At the same time, the expectation was that investment grade and corporate bonds would likely continue to do well as credit spreads (the extra yield an investor gets for taking on credit risk) declined due to ongoing favorable credit conditions. Declining credit spreads result in higher prices for bonds with credit risk. Emerging market debt was likely to follow corporate bonds as investors continued to gravitate towards sectors that offered income. Here is how returns have played out through April 30th:

iShares Bond ETF NAV Returns (12/31/2013-4/30/2014)

Surprisingly, all of the returns are positive. Not quite what most people expected. A few other interesting stories:

  • The 20+ Year Treasury Bond fund returned +10.07%, not bad for a year when we expected rates to go up. We have seen steady buying from a range of investors including wealth managers looking at add yield and pension funds looking to better manage their liabilities. Year to date the iShares 20+ Year Treasury Bond Fund (NYSEARCA:TLT) has grown by $1,321 million.
  • The decline in rates has helped boost performance across asset classes, with Treasurys, the broad Aggregate, investment grade corporate, and municipal bonds sectors all doing well. Corporates and municipals outpaced broad maturity Treasurys as we did see credit spreads continue to decline throughout the year. We also saw flows into these sectors with LQD taking in $826 million and MUB taking in $64 million. The MUB numbers reflect broader investor sentiment as some investors have been slow to return to the municipal market after the performance and outflows of 2013.
  • High yield had solid performance, but it lagged investment grade. Although high yield credit spreads declined, high yield tends to have less interest rate sensitivity than investment grade and so did not see much benefit from the decline in yields. That’s because more of the yield in this asset class comes from credit spreads rather than interest rates. Thus the bonds appreciate less when interest rates decline. Some investors became more cautious on the high yield sector during the year, reflected in the $2,159 million of outflows that we saw from HYG.
  • The story in emerging markets bonds was mixed. U.S. dollar bonds benefitted from the same favorable credit environment that helped corporates. Local currency bonds struggled as the U.S. dollar strengthened, which hurts the return of a foreign currency investment. Flows have reflected this as EMB has taken in $584 million year to date and LEMB has seen $28 million of outflows.

The question from here, of course, is what happens next. I still expect that we will see gradually higher interest rates, as the Fed continues to reduce their Quantitative Easing program and the market moves closer to the first increases in the Fed Funds rate that are likely to come next year. Credit spreads are likely to remain near current levels in the near term, but it will be challenging for them to decline much further as they are approaching levels that we haven’t seen since 2007. As we wrote earlier, we believe that U.S. dollar EM could benefit in the near term as it catches up to corporate bonds, but it comes with the sovereign credit risk of emerging market bond issuers. It will be interesting to see if fixed income continues to take the ball and run. Let’s get back to the game and see how things play out.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy.

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. For standardized performance for the funds discussed, please click here.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax (NYSE:AMT). Capital gains distributions, if any, are taxable. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency and its return and yield will fluctuate with market conditions.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets, in concentrations of single countries or smaller capital markets.