Bond Market Perspectives | Week of July 21, 2014

posted 7/24/2014 in Investments

Highlights

  • Current weakness in the high-yield bond market is the most notable since January 2014 but modest when viewed in historical context.
  • We still believe high-yield bonds should remain a cornerstone of fixed income portfolios despite recent challenges.

High-Yield Pullback

Profit taking has hit the high-yield bond sector and has led to lower prices to start the third quarter of 2014. Since peaking late last month, the average yield of high-yield bonds has risen by 0.5% to 5.3% with the average yield spread to Treasuries widening to 3.9%. Even after the recent increase, yields remain low and spreads remain narrow by historical comparison [Figure 1].


The pullback overall remains modest in historical context but is the largest since January of this year. A number of factors have contributed.

  • Higher valuations. A strong first half for high-yield bonds that saw the average yield drop below 5% provided an opportune occasion for some investors to take gains and reduce exposure.
  • Portuguese bank troubles. The revelation of additional financial troubles at Portugal's second largest bank, Banco Espirito Santo, added to selling pressure. Fears of systemic market risk weakened high-yield bond prices even though risks began to subside as the Portuguese government and central bank announced it would provide assistance and that private investors were ready to inject capital.
  • Geopolitical risks. Global conflict generally fosters uncertainty, which can drive bond investors into higher-quality assets and away from high-yield bonds. The Malaysian airlinetragedy and military action in Gaza provided a one-two combo last week.
  • Yellen's "reach for yield" comments. In a report to Congress, Federal Reserve (Fed) Chair Yellen once again mentioned that a "reach for yield" was coming under scrutiny at the Fed. Yellen's comments were, on balance, market friendly since she exhibited a great deal of caution about when the Fed would ultimately raise interest rates, which is generally positive for more economically sensitive fixed income sectors such as high-yield bonds. However, singling out lower rated loans was a minor negative and weighed on the market. 
  • Additional Russian sanctions. Sanctions targeted to limit access of several large Russian companies in the energy, banking, and defense sectors to U.S. dollar-based financial markets increased concerns of default risk that could arise from a lack of market access.

The above confluence of events led to lower prices and notable mutual fund outflows. High-yield bond mutual funds and exchange-traded funds (ETF) recorded their greatest weekly outflows in a year, according to Lipper data. In a less liquid sector such as high-yield bonds, a heavy dose of selling at once can have an outsized impact.

In our view, weakness may be limited due to positive factors still supporting the sector. Economic
data continue to show improvement from a poor first quarter. The July Philadelphia and New York Fed surveys, gauges of regional manufacturing activity and some of the first data points on third quarter economic activity, were stronger than expected and bode well for the upcoming national Institute for Supply Management (ISM) manufacturing survey, which we believe is one of the better leading indicators of economic strength. Additionally, weekly jobless claims for the week ending July 12, 2014, fell to the lowest level since 2007.


Second quarter 2014 corporate earnings reporting season is just underway, and initial reports indicate continued modest growth. Earnings have increased 5% year over year, according to the 16% of S&P 500 Index companies that have reported earnings thus far. Revenue growth is up approximately 3%. Positive earnings growth bodes well for companies' ability to repay debt obligations and lends support to a low default environment. Moody's global speculative default rate declined to 2.2% for the 12-month period ending June 2014.


Although high-yield bond prices declined, the bank loan market has been more resilient. The
high-yield bond market is down 0.6% month to date through July 18, 2014, compared with a positive 0.1% gain for the leveraged loan market. Yellen's comments on reaching for yield were more targeted to the leveraged loan market, yet this segment of the lower rated bond market outperformed. A negligible yield differential between high-yield bonds and bank loans likely helped loan resiliency [Figure 2]. The demand for yield remains robust, largely due to the Fed's keeping short-term ratesnear zero. Absent a change in rate hike plans or Yellen's comments regarding a go-slow approach, her comments may ring hollow.

It is worth noting that Yellen also pushed back on high-quality bond valuations by stating the Fed's
forecast of future short-term rates remains valid. But the bond market has a different opinion with futures still indicating the Fed will take longer to raise interest rates and ultimately not raise rates as high as the Fed has forecasted. Fed fund futures pricing indicates year-end 2015 and 2016 overnight rates that are 0.3% and 0.7% lower than the average Fed forecast.


We agree that all segments of the bond market remain expensive, but that is likely to remain the case as long as the Fed remains bond friendly, economic growth remains subpar, and inflation remains low by historical comparison. We continue to believe a lot of the good news about the Fed is likely priced in, the economy continues to exhibit strength after a disappointing first quarter, and inflation likelybottomed during the first half of 2014. We expect interest rates may move gradually higher in response to these factors, even though geopolitical risk may keep bond yields anchored near current levels over the very near term. Higher valuations indicate trimming or rebalancing may be prudent, but higher yielding segments of the bond market, backed by good fundamentals, remain a way to seek protection from interest rate risk while also providing a total return opportunity even if rates do not rise.


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.


This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.


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.
High-yield/junk bonds are not investment-grade securities, involve substantial risks, and generally
should be part of the diversified portfolio of sophisticated investors.


INDEX DESCRIPTIONS

The Barclays US Aggregate Bond Index is a broad-based index that measures the investment grade,
US dollar-denominated, fixed-rate taxable bond market.

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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