Financial Market Volatility Returns

Last week proved to be an interesting week in the fixed income world, as bond markets moved in the opposite direction from what most investors predicted for 2014. Treasury yields fell Thursday and Friday on fears of weaker than expected economic growth overseas, particularly in emerging markets. This yield movement caused Treasury prices of all maturities, especially those with a maturity longer than five years, to rally sharply.  At the same time, corporate bonds rallied, but not as much as treasuries. The two most popular trades coming into 2014 were short duration and long credit. As measured by the Stone and McCarthy survey, fixed income investors currently hold 97% of benchmark duration, close to a record underweight. Investors also have a near record allocation to corporate bonds of 34.9%, according to the SMR money manager survey, 0.1% away from the all-time record. We have taken a different tack in client portfolios. While we believe that, over the course of 2014, rates will likely move gradually higher based on stronger U.S. economic growth, we are letting duration decline naturally by allowing bonds to roll down the yield curve. We also are underweight corporate bonds, as the additional compensation gained by owning corporate bonds fell last year to the lowest levels since before the financial crisis. The bottom line is that our investors benefited from the rally in high quality bonds last week, and were protected from the volatility in the corporate sector. With volatility usually comes opportunity, and we are waiting for the right time to make a move back into corporate bonds when their prices are indicative of their risk.