As we close out 2016 and look ahead to 2017, this question, as it has been numerous times over the past few years, is on the top of investors’ minds. But before we opine on the direction of the bond market in year ahead, we always find it helpful to first look back and evaluate where we’ve been.
Two thousand sixteen can be characterized as having been “good not great” for the bond market. Yields fell sharply in the first half of the year, but quickly reversed in November as the prospects for stronger economic growth and inflation under the Trump administration caused interest rates to rise. In the end, a small increase in yields for most maturities was offset by income generation and gains from credit spread tightening, resulting in modestly positive full year returns.
Yield Change Y/Y – All Maturities
Looking forward, we acknowledge some market forecasters are predicting that interest rates are likely to continue their march higher as the U.S. finally breaks out of the sluggish growth and inflation environment that we’ve become accustomed to since the great recession. Predicting interest rates is not a winning strategy, in our view, and we are skeptical of such certainty. A deeper look at economic and policy trends reveals that significant nuances must be considered when thinking about bond investing, both in 2017 and beyond.
First, there is a great deal of uncertainty regarding fiscal policy implementation. At this stage, we know that certain items such as tax reform are at the top of the agenda for the new administration. What we haven’t seen is the framework in which these reforms will be structured, nor do we know over what time period they will be implemented. The same uncertainty applies to fiscal stimulus via infrastructure spending. While it’s fair to assume that lower tax rates and increased spending would be a positive contributor to economic growth, at least in the short term, other administration policies, such as trade protectionism and limits on immigration, would likely to be detractors from growth.
Second, inflation is likely to remain constrained moving forward. Not only is the Federal Reserve on a tightening path (which has the largest effect on short-term bonds with limited price sensitivity to a change in rates), but the U.S. Dollar has risen sharply in recent weeks. Both of these tend to limit inflation. In addition, while higher commodity prices will boost inflation early in the year, these base effect gains will lapse as we move through 2017.
Third, much of the rest of the developed world is going through a prolonged growth downturn, likely causing foreign yields to stay low for the foreseeable future. This is especially true in Japan where the Central Bank has implemented a policy to manipulate its bond market. Specifically, the BOJ has pledged to keep 10-year Japanese Government Bonds at 0%. The relationship between U.S. and Japanese yields is currently near record wides. The same is true for U.S. and German Bund yields. Both should provide support for our markets as foreign investors take advantage of the relative value opportunity U.S. bond yields provide.
And, finally, there is no shortage of potential risk and volatility in the global financial marketplace. Overleverage across developed market economies, a continuation of capital outflows in China and currency driven dislocations in emerging economies are a few things that we are watching closely. Should these trends create volatility, high quality U.S. bonds would do quite well. The early months of 2016 provided an appropriate case study for this.
Could rates move higher during certain periods of 2017? Sure. Will the bond market enter a sustained bear market where yields correct sharply to the upside? Unlikely. And even if rates do move higher over the course of the year, bond investors can still make a positive return with relatively low levels of volatility because of the income generation bonds provide.
We consistently remind our clients that timing and predicting interest rates has proven to be one of the most difficult tasks in all of investing. Long-term academic research supports this conviction. Our views on interest rates, particularly over the short-term, should be taken with a grain of salt, as should those of other market participants. Our investment philosophy guides us to manage bond portfolios based on a long-term plan that takes into account individual risk tolerances, time horizons and liquidity requirements, and this plan is executed in a manner consistent with what investment grade bonds are – a safe, low volatility investment that generates consistent income and provides a hedge against riskier and more volatile sectors of the financial markets. We believe that value can be added through prudent credit selection and smart, tactical sector allocation, which allows us to maximize yields while minimizing risk. After all, income will be the predominant driver of long-term bond returns, despite what happens with rates.