Taxable Fixed Income: A Look Back and a Look Forward

After a bumpy ride in 2013, taxable credit spreads have tightened modestly and corporate bond investors have benefited from a return to a more traditional bond market environment.  One way to analyze a taxable bond is to look at its spread. If we take the difference between the yield on a taxable bond and the yield of a US Treasury bond of similar maturity, we arrive at the credit spread. Historically, credit spreads move inversely to equity prices and the direction of Treasury yields. If the stock market moves up and Treasury rates rise, credit spreads likely shrink as investors feel comfortable taking on additional risk. In late May 2013 through early July 2013, we saw the opposite: Credit spreads widened suddenly as rates rose in response to investor fears that the Federal Reserve would trim its monthly bond-buying program. The market over-reacted and it took another six months for the Fed to officially announce a reduction of purchases. During those six months, as equity markets continued their ascent, fixed income markets prepared by reallocating capital within taxable sectors. Credit spreads are now the tightest in more than five years. We have taken advantage of the spread tightening last quarter and reduced our exposure to credit spread risk, while locking in out-performance.  In 2014, we expect that interest rates will trend higher as the market prepares for a complete removal of Fed stimulus by year end. Stronger economic data and improving consumer and business confidence will help credit spreads tighten modestly, accompanied by brief dips. Fixed income investors can expect an environment with healthier interest income more consistent with historic norms.   We expect that, as rates continue to normalize in 2014, there will be a better entry point for our clients to realize value in long maturity taxable fixed income and, specifically, corporate credit.