Bond market update

LPL F INANCIAL RESEARCH

Bond Market Perspectives



Anthony Valeri, CFA



Market Strategist LPL Financial

Member FINRA/SIPC

Page 1 of 4

February 19, 2013


No Love for Bonds



High-quality bonds remain unloved in financial markets in 2013. After modest improvement during the first full week of February, weakness resumed with the 10-year Treasury yield rising back to the 2.0% threshold. Last week’s Treasury auctions saw mixed results with the 30-year Treasury bond garnering some affection in a strong auction, but 3- and 10-year note auctions met lukewarm demand. The fact that stronger demand did not emerge given the substantial rise in yields over the past two months disappointed investors and led to lower prices across the high-quality bond market.

The financial industry also turned a cold shoulder to bonds. A few Wall Street firms issued warnings for investors with larger fixed income allocations due to potential interest rate risk and the prospect of losses. FINRA, the Financial Industry Regulatory Authority, offered a similar cautionary note last week. Both cited ultra-low bond yields, and corresponding less interest income, will not offer much protection against rising interest rates. Price declines may overwhelm interest income, leaving investors with greater-than-expected declines. One Wall Street firm recommended a lower-than-benchmark allocation of government bonds. Considering government bonds comprise roughly 75% of the broad Barclays US Aggregate Bond Index, such a recommendation is hardly earth-shattering.

We have long advocated a significant underweight to government bonds, favoring investment-grade corporate bonds, municipal bonds, and high-yield bonds as the preferred defense against higher interest rates over the past two years. As we discussed in the February 5, 2013,

Bond Market Perspectives: Winter Hits the Bond Market, these sectors can allow investors to play defense against rising interest rates. We also advocate these sectors because their valuations are significantly better than Treasuries. Although Treasury valuations have cheapened recently, inflation-adjusted Treasury yields have a long way to go before reaching their longer term average [Figure 1]. Our favorite valuation barometer, the inflation-adjusted yield of the 10-year Treasury, has turned positive, albeit marginally, for the first time since August 2011.

We expect Treasury valuations to cheapen over time but only gradually due to several factors that will likely keep Treasuries expensive compared to historical norms. Over the near term, the factors below may limit the rise in yields and may even engineer a return to lower yields in coming weeks.

1. Sequestration.
4. Broad-based spending cuts will take effect on March 1, 2013, absent an agreement in Congress to agree upon longer term deficit reduction measures. The spending cuts will total $85 billion over

　



Highlights



We continue to hold to our low-single-digit return for the bond market in 2013, despite modest additional weakness in high-quality bonds.

We believe a portfolio of high-yield bonds, bank loans, and intermediate bonds, with an emphasis on investment-grade corporate bonds and municipal bonds remains the preferred way to navigate a low-return environment in the bond market.



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Treasury Valuations Have Improved but Remain Very Expensive ‘13 ‘10 ‘11 ‘12 ‘09 Average ‘08 ‘07 ‘06 ‘05 ‘04 ‘03 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% Real Yield (10-Year Treasury Yield Minus Core CPI Year Over Year)

Source: Bloomberg, LPL Financial 02/15/13

BOND MARKET PERSPECTIVES

LPL Financial Member FINRA/SIPC Page 2 of 4

the remainder of 2013 and will be a further drag on economic growth in addition to the tax increases that took effect on January 1, 2013. So far, tax hikes have shown little impact on economic data, but along with spending cuts will have a gradual impact over time. Both factors should reinforce our expectation of a sluggish growth environment and may help support bond prices.



..Government shutdown. Should Congress fail to agree on a new budget by March, 27, 2013, the government will shut down. Non-essential government workers will be furloughed and payments to federal contractors will be halted. A brief shutdown is not likely to have much economic impact, but a longer shutdown would have negative knock-on effects to other segments of the economy and significantly impact overall economic growth.

..Italian elections. Much of the improvement in European sentiment is due to fiscal reforms implemented in both Spain and Italy. Italian elections on February 24 – 25, 2013, may determine whether Italy proceeds with needed reforms. A pro-reform coalition is still the most likely outcome, but the center-right party, and its anti-euro rhetoric, has narrowed the deficit according to recent polls. Italian election uncertainty has already provided modest support to high-quality bonds and may lead to renewed safe-haven flows depending on the election outcome.

The following longer term trends are ongoing and help support a low-yield environment and expensive bond valuations.

1. An accommodative Federal Reserve (Fed).
4. The Fed remains very accommodative by purchasing $85 billion of Treasuries and mortgage-backed securities (MBS) per month (over $100 billion including reinvestments). The Fed will also refrain from raising interest rates until the unemployment rate drops below 6.5%, a rate that is not likely to be reached until late 2014/early 2015. The lack of a potential rise in interest rates, historically one of the biggest movers of bond yields, is likely to keep bonds expensive. Furthermore, as we discussed in our January 8, 2013 Bond Market Perspectives: Sour Start to New Year, prior episodes where the Fed has ended bond purchases have led to lower yields.
5. European risks.
8. The European Central Bank (ECB) has effectively ring-fenced risks for now with liquidity backstops and its Outright Monetary Transaction (OMT) bond-purchase program, which has yet to be activated. However, peripheral European countries still need to reduce a large debt burden, and reforms will need time to work. Recent events in Italy and Spain highlight that political risks remain on the path to reform and growth, which, as Europe remains in recession, needs to resume to help reduce debt burdens.
9. Favorable supply-demand backdrop.
12. After taking into account Fed bond purchases, the net new supply of bonds remains negligible. At the same time, demand remains high for fixed income investments from a variety of investors, institutional and individual. Bond prices may continue to benefit from the favorable supply-demand backdrop.

Our favorite valuation barometer, the inflation-adjusted yield of the 10-year Treasury, has turned positive, albeit marginally, for the first time since August 2011.

Prior episodes where the Fed has ended bond purchases have led to lower yields.

BOND MARKET PERSPECTIVES

We still hold to our Base Case of low-single-digit returns for the bond market, as outlined in our

Outlook 2013. Nonetheless, the bond market continues to trade poorly, and over the coming weeks upward pressure to interest rates may remain. However, both short-term and longer term trends argue that further weakness is likely to be limited. We believe Treasury yields may be establishing a new trading range, defined by a 1.9 – 2.4% yield on the 10-year Treasury like the range that existed from late 2011 to early 2012, and similar to the pattern of recent years where the bond market was characterized by long periods of range-bound trading [Figure 2]. Over the long term, we view a gradual stair step toward higher yields as more likely rather than a steady ascent, given the factors outlined above.

We acknowledge there is interest rate risk in the bond market, but long-term bonds, which we are currently avoiding, are where the bulk of this risk lies. Furthermore, given lower yields limit the defensive properties of bonds, an emphasis on higher yielding sectors can help offset this risk. We believe a portfolio of high-yield bonds, bank loans, and intermediate bonds, with an emphasis on investment-grade corporate bonds and municipal bonds remains the preferred way to navigate a low-return environment in the bond market.

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We still hold to our Base Case of low-single-digit returns for the bond market, as outlined in our

Outlook 2013.

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A New, Higher Trading Range Is Likely Developing for Treasuries May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 Jan 11 3.75% 3.25% 2.75% 2.25% 1.75% 1.25% 10-Year Treasury Yield

Source: Bloomberg, LPL Financial 02/15/13 LPL Financial Member FINRA/SIPC Page 3 of 4