Don’t Drink the Cool Aid that Bonds will Under-perform

Reports of the demise of the bull market in bonds are exaggerated (apologies to Mark Twain!!). The volatility may provide opportunity for shrewd investors. We are in the camp that interest rates will not rise as high or as fast as many predict. In fact, rates could remain relatively low for some time against the backdrop of stubbornly low global interest rates.

While we expect some correction in the fixed income markets, we see value in munis, high yield and EM bonds. Investors should add to positions when opportunities present themselves. In the government markets we are seeing strong appetite among institutional investor for long-term bonds – both treasuries and corporates. We think that government and corporate issuers may increase issuance of long duration bonds in response to investor demand. Will we see 100-year maturities treasuries again?

  • US bonds are among the most attractive in the world. Global demand for US bonds will continue and perhaps increase. US 10-year government bonds currently yield the most that they have relative to German bund yields in 27 years!
  • Corporations, which are flush with cash and reluctant to embark on capital expenditure, are issuing bonds, but not enough to meet the demand of global buyers.

The search for yield will continue, as interest rates – and yields – are likely to remain low.

  • Fears that tax rates may cut have precipitated a sell-off in municipal bonds. In our view, too far, too fast. We see opportunities in this market. Scarcity of munis will support prices, and, hence, total return in the sector.
  • Yield seekers will also continue favoring investment grade corporate bonds, high yield bonds and emerging markets bonds.
  • Investors looking for income should be asset class agnostic and consider dividend paying stocks, REITS, preferred stock and other income bearing securities.
  • Don’t run away from long term bonds – could do better in 2017 than some investors think. With some 30-year investment grade corporate bonds yielding 5% or more, there is increasingly strong demand from institutional investors.
  • The dollar will remain strong relative to other currencies due to the US’s favorable economic growth and interest rates relative to many developed markets. Is parity with the Euro ahead?

In summary, don’t get too far ahead of yourself and drink the cool aid that bonds will underperform. Investor fears of higher interest rates have caused volatility, which we believe presents opportunities in the fixed income markets. Global central banks continue to intervene in the markets in such a way that natural market mechanisms cannot function properly

Jim Sarni, CFA, is Managing Principal of Payden & Rygel.

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