January 28, 2014

Bond investors have been on edge since May, when Federal Reserve officials hinted at plans to begin reducing or "tapering" the central bank's $85 billion in monthly asset purchases.

As the market began pricing in this eventuality, long-term Treasury yields rose sharply, bond funds suddenly saw heavy outflows, and returns for most fixed income sectors turned negative for the year. (See chart below.)

"There's an investment mantra that says, 'Don't fight the Fed,'" says Mike Gitlin, T. Rowe Price's head of fixed income, referring to the central bank's ability to influence financial markets. "It works both ways. We've seen some dislocations as people adjust to the fact that the Fed is going to be less accommodative."

Fixed Income Sector Total Returns

Note: Chart represents total returns for the following: Credit Suisse High Yield Index; J.P. Morgan Emerging Markets Bond Index Global; and Barclays U.S. Corporate Investment Grade Bond, U.S. Treasury Bond, U.S. Mortgage Backed Securities, Municipal Bond, and Global Aggregate ex-USD Bond indices.

Source: T. Rowe Price.

But bond markets began to stabilize in the fall, helped by the Fed's unexpected decision in September to not start tapering then. Investors also were heartened by Fed officials' assurances that the fed funds rate will remain exceptionally low for a considerable time after its bond buying ends.

These efforts to differentiate between tapering asset purchases and tightening monetary policy, which is not on the immediate horizon, appear to have succeeded. When tapering finally came—in the form of the Fed's December announcement that it would begin reducing its monthly asset purchases—bond markets had a generally subdued reaction.

"The market seems more comfortable with tapering," says Steve Huber, manager of the Strategic Income Fund. "With tapering beginning, we don't expect to see the same level of volatility in interest rates and credit markets that we experienced last May."

Adds Gitlin, "I would give the Federal Reserve a high mark in terms of preventing a deeper recession or even a depression, but now we're at an inflection point. With the economy doing reasonably well, the Fed's decision to reduce its purchase program was an appropriate step."

Although bond prices fell and yields rose as the market began pricing in a reduction in Fed stimulus, many bonds remain vulnerable to a further increase in rates. Despite rising sharply in 2013, the closely watched 10-year Treasury yield still sits below longer-term averages, and most credit sectors offer limited additional yield over Treasuries of comparable maturity.

"Valuations look somewhere between fair value and expensive, depending on the particular fixed income asset you're looking at," Gitlin says. "It's hard to claim that bonds are cheap."

For example, he notes that the typical U.S. investment-grade corporate bond yields about 3.25%. That's better than the all-time low, near 2.60%, but the 10-year average is around 4.80%.

Another worry for bond investors is decreased market liquidity. Stricter regulations have compelled the large investment banks that broker most bond transactions to significantly reduce their bond inventories. Their reluctance to step in to buy securities can exacerbate price swings at times when sellers dominate the market.

"Liquidity in the marketplace is not great, and I don't think it's going to get better any time soon," Gitlin says. "As asset managers, we have to think really hard about what we own, because exiting positions is probably not going to be as easy as getting in."

Opportunities

For investors willing to accept higher volatility, constrained liquidity, and currency risks, emerging markets debt may offer some key advantages heading into 2014.

A notable development within emerging markets is the rapid growth of the corporate sector, which has eclipsed the U.S. high yield market in size. Corporate bonds from developing markets, primarily issued in dollars, offer higher yields than U.S. corporate bonds of similar credit quality.

In addition, yields on emerging markets sovereign debt compare favorably with developed market government bonds. Governments now issue considerably more debt in local currencies than in U.S. dollars, providing investors with diversification opportunities and the potential for currency gains.

"One reason for this rapid growth in emerging markets corporate and local currency bonds is substantive improvement in credit quality," says Andrew Keirle, manager of the Emerging Markets Local Currency Bond Fund. (See chart below.) "Second, the asset class has matured and become more accessible. Third, investor demand has risen a lot."

EM Sovereign Debt Now High Quality

Emerging markets, which had been a prime destination for "easy money," resulting from Fed policies, were disproportionally affected by tapering concerns. Slowing growth in many countries also contributed to large capital outflows.

These markets have stabilized in recent months but still face risks emanating from U.S. policy. "Shorter term, rising rates and lessening liquidity are going to have an impact on those markets that have seen significant investor inflows," Keirle says. "But medium term, there is still demand from investors internationally, as well as growing domestic demand."

Some countries face stronger near-term headwinds than others. Brazil, India, Indonesia, South Africa, and Turkey have drawn attention for being especially vulnerable to capital flight. On top of weaker growth and political resistance to difficult economic reforms, they possess large trade and budget deficits, making them reliant on external financing.

"The outlook for emerging markets is differentiated—it's not the same story across the board," says Keirle. "There are some positive signs with regard to growth coming from Eastern Europe and Mexico, and parts of Asia are reporting decent trade numbers. If we see improvement in the growth cycle, there are a lot of emerging markets that should do well."

In contrast with emerging markets bonds, high yield bonds and floating rate bank loans performed well in 2013 as investors were willing to take on greater credit risk and potential volatility in exchange for higher yields and less sensitivity to rising rates. Defaults also remained low thanks to a steadily healing economy and opportunities for companies to refinance maturing debt at lower rates.

"High yield had a great 2013, and that can't last forever. But we think the near-term momentum continues to favor the sector," Huber says. "There are some early warning signs that credit quality is deteriorating, but we don't think we're at the point where it really is a danger."

For investors concerned about interest rate risk but uncomfortable with the greater credit risk of high yield bonds and bank loans, funds that invest in high-quality debt with shorter maturities are an option. Although their yields are currently very low as a consequence of Fed policy, short-term bonds have performed relatively well during previous cycles of rising interest rates.

Ted Wiese, manager of the largely investment-grade Short-Term Bond Fund, cautions that some fund managers may be reaching for yield in a low-rate environment by buying higher-risk debt. "There are a lot of different short-term offerings, and investors need to look into what they're considering buying and understand the risks," he says.

Diversification

Although interest rates are likely to continue moving higher, they are not necessarily going to increase rapidly or in a straight line. Unemployment remains high, economic growth is subdued, and inflation is low. In addition, the Fed has committed to holding short-term rates near zero after it ends asset purchases, which should keep downward pressure on yields for shorter-maturity bonds.

"In the near term, we think interest rates are going to continue to go up," Huber says. "But because the Fed is on hold for an extended period of time and may not tighten rates until 2015 or even 2016, we think that yields are going to stay fairly low, absent some unexpected strengthening in the economy or inflation."

Moreover, higher yields could entice investors and thereby limit an upturn in rates. And although there has been some rotation from bonds into equities in recent months, investors appear to recognize the value of a diversified portfolio following two deep stock market declines in the past decade.

"While fixed income doesn't look incredibly attractive, there are areas that look decent," Gitlin says. "I'd be careful when people say that there will be no demand for fixed income as rates go up, because I really don't believe that to be the case. There will be plenty of pockets of demand, such as individuals, defined benefit plans, and insurance companies, as valuations improve and yields rise."

Diversification cannot assure a profit or protect against loss in a declining market. Yields can vary with interest rate changes, and certain holdings are subject to credit risk. International investing, particularly in emerging markets, entails additional risks, including currency risk. Some income from municipal bonds may be subject to taxes.