Bond Market Perspectives | Week of August 4, 2014

posted 8/8/2014 in Investments

Highlights

  • Last week's batch of top-tier economic data failed to act as a catalyst for additional bond gains.
  • June and July bond performance may be representative of what investors can expect after a strong start to the year.


Bonds Take a Breather

After a strong start to 2014, bonds took a breather in July with the broad Barclays Aggregate Bond
Index posting a modest loss. The decline follows a meager 0.05% return in June. As we have
commented in this publication previously, the pace of bond performance was unsustainable, and June and July performance may signal exhaustion. Last week witnessed bond price declines despite some support from weaker stock markets.

Unlike March 2014, the last time the broad index declined, price declines were more broadly
distributed in July, even if modest in most cases [Figure 1]. From high-quality Treasuries to high-yield bonds, total returns were negative, but year-to-date returns remain firmly positive. Among taxable bonds emerging market debt managed slightly positive returns as interest income marginally offset softer prices, while Treasury Inflation Protected Securities and investment-grade corporate bonds were flat. Foreign bonds hedged for currency movements led performance for the month as they continued to benefit from European bond strength. In general, July performance should be viewed in the context of what has been, and still is, a good year for bond investors.

Aside from sectors, long-term bonds were one of the few segments of the market to manage gains in July 2014. Short and intermediate bond prices, on average, declined in anticipation of a Federal Reserve (Fed) rate hike in late 2015. Long-term bonds managed a modest gain of 0.25%, according to Barclays index data, benefiting from geopolitical concerns and lingering doubts over how high the Fed may ultimately raise interest rates.

Municipal bonds also managed gains for the month of July, reversing late June/early July
underperformance. Continued low issuance, fading Puerto Rico concerns, and heavy reinvestment
needs helped fuel modest price gains.


Another Catalyst Needed

We believe June and July are broadly representative of what bond investors can expect going forward.

Year-to-date strength has led to lower yields and higher valuations across the bond market. In last
week's commentary (Bond Market Perspectives: Calling the Fed's Bluff), we discussed how
high-quality bonds would need another catalyst to push bond prices higher and yields lower.
Last week's batch of top-tier economic data failed to produce that missing catalyst for additional price gains. The July employment report showed payrolls increased by more than 200,000, registering the sixth consecutive monthly gain in excess of 200,000. Also, both the July Institute for Supply Management manufacturing survey and second quarter economic growth (as measured by gross domestic product) were stronger than expected. A benign statement from the Fed and stock market volatility lent support to bonds, but neither economic data nor the Fed provided the catalyst for another round of bond gains.

High-Yield Pullback

The better economic data should provide support to high-yield bonds, a sector in the midst of its
biggest sell-off since spring 2013. An illiquid trading environment has exacerbated price declines that first began in June on profit taking and then continued through July as equity markets remained volatile on a host of concerns from geopolitics to earnings to the economy. High-yield spreads have increased by over 1%, the sharpest move since 2013 [Figure 2]. High-yield bonds may remain volatile near term, but if the average yield (which is now 5.9%) increases, it should help bring out demand given still-low yields across high-quality bond markets.

Earnings reporting season and the latest release of the Fed's Senior Loan Officer Survey bode well for a continued low default environment -- a key underpinning for high-yield bonds. Second quarter earnings are on pace to rise nearly 8% year over year with 65% of companies reporting. The Fed's lending survey showed a growing number of institutions easing lending standards. Easier lending standards reduce the probability of default, which is one reason why this survey has been such a good leading indicator of defaults [Figure 3].

While high-yield volatility has startled some, we view it as a natural market correction. Bank loans, a similar category, also declined in July but much less so in keeping with the sector's lower historical volatility compared with high-yield bonds.

Our main takeaway from last week's bond market activity is that top-tier economic data did not
provide the fuel for additional gains. Conversely, the not-too-hot, not-too-cold nature of the jobs
report may keep the Fed at bay and leave bond prices and yields range bound near current levels until the next set of top-level economic data.

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to
provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Index performance is not indicative of the performance of any investment.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields
will decline as interest rates rise, and bonds are subject to availability and change in price.
This research material has been prepared by LPL Financial.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

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