By Colin J. Lundgren, CFA, Head of U.S. Fixed Income
Pardon the title, but coupon-like total returns really do taste good to me and many other fixed-income investors. That's because last year's market returns were so bad - in stocks, bonds and alternatives. 2015's total return for an equal-weighted, diversified mix of assets was the worst since 1974, excluding the great financial crisis. Bonds were partly to blame, as most sectors produced flat-to-negative total returns (coupons were wiped out by price losses) due to slightly higher Treasury yields and significantly wider risk premiums, especially for low quality and/or energy-related corporate bonds. Bonds did not act as a shock absorber, which is atypical in difficult market environments.
The first quarter of 2016 was a different story. Market expectations were low, volatility was high and sentiment cautious. But every sector of the taxable bond market produced positive returns that exceeded 2015 returns. Moreover, we think the friendly combination of a slow moving central bank, reasonable credit fundamentals and fair-to-attractive risk premiums should allow investors to continue to enjoy their coupons in 2016.
1. Fed tightening is moving slow and easy.
The Federal Reserve's "dot plot" suggests two hikes in 2016, and the bond market is pricing in even less. The Fed appears focused and concerned about global developments. This makes us less fearful of a central bank policy mistake and should limit the upside in rates this year.
Source: Federal Reserve, March 31, 2016.
2. High-yield risk premiums are commensurate with higher defaults.
We expect an increase in default activity in the next 2-3 years, which will cause the headline default rate to exceed the long-term average rate of 4.1%. However, the increase will be largely concentrated in the energy, metals and mining sectors. Outside of those sectors, yield spreads appear to fairly compensate investors for higher defaults. Security selection will remain critical in this environment.
Sources: Moody's, JP Morgan, Columbia Management Investment Advisers, LLC, March 31, 2016
3. Higher-quality bonds: Investment-grade corporates over Treasuries.
We think Treasury yields are too low - by about 0.5% - based on current conditions, forward-looking measures and expected policy response. But our fear of a spike in interest rates anytime soon is tempered by the Fed's focus on global conditions. Investment-grade corporate bonds provide historically wide spreads or yield cushion, which more than compensate investors for credit risk. We expect higher Treasury yields and tighter investment-grade corporate bond spreads to mostly offset and result in coupon-like returns for high-quality corporates.
Sources: Barclays, Columbia Management Investment Advisers, LLC, March 31, 2016
Political consultant James Carville once said, "I want to come back (to life) as the bond market. You can intimidate everybody!" Unfortunately, the bond market may have intimidated many investors by repeatedly calling for significantly higher interest rates and a credit market meltdown. As a result, some investors moved to the sidelines while others responded by stretching for yield in unsafe places or imprudent ways. We think the right answer today is somewhere in the middle. Don't hold excess cash or overweight CCCs. Don't expect negative returns or double-digit returns from bonds. It's an okay environment for bonds, which should produce coupon-like returns, which is more than okay by me.
The views expressed in this material are the views of the author through the date of publication and are subject to change without notice at any time based upon market and other factors. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. This information may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable. Past performance does not guarantee future results. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance. Please see our social media guidelines.