A variety of issues affected the fixed-income sector in 2011, starting with Meredith Whitney’s bearish predictions for municipal bonds early in the year.
Many black swan scenarios didn’t play out as expected in 2011, fixed-income experts say, and are not likely to do so in 2012, though concerns over the situation in Europe lingers.
Here are the broad fixed-income views and specific strategies for 2012 as outlined by analysts from AXA, Bond Desk, LPL and Eagle Asset Management.
AXA’s Ombretta Signori wrote in the group’s 2012 outlook report that global economy’s “sluggish economic environment, combined with further quantitative easing and problems surrounding the debt crisis, will most likely weigh on long-term yields.”
Still, the European-based investment manager says, the group expected German and U.S. long-term yields to move higher from current levels. “Our fair value estimates for 10-year US German Bunds are 3.5% and 3.3%, respectively,” she explained. With the Fed’s quantitative easy and the European debt crisis taken into account, AXA analysts anticipate even lower long-term yield estimates (3% and 2.6%, respectively).
“Year-to-date, only the “classic” safe haven bets have rewarded investors for the pain and stress they have had to digest in 2011 … U.S. government 10-year bonds have provided investors with an annualized return of roughly 17% (January–November 2011), versus a 10% return on German Bunds,” outlined Signori.
Bunds started to lose ground relative to Treasuries when investors began to think about the break-up of the euro.
For 2012, the probability of extreme scenarios for Treasuries and Bunds is low. Returns sharply higher or lower than 5%, she says, are not likely, and “…Treasuries and Bunds should not be relied upon to guarantee decent performance in 2012,” the investment manager concluded.
More Eurozone Fallout
LPL Financial’s Anthony Valeri, CFA and market strategist, sees more instability ahead for 2012. “Summit fever will likely continue in 2012 and suggests that investor expectations will lead to volatile market,” he said.
“An increasing number of summits reflect an escalating sense of urgency among European leaders to deliver more robust solutions to the European debt problem and one of the reasons we believe yield differentials between Treasuries and corporate bonds, both investment-grade and high-yield, will converge in 2012,” explained Valeri.
The municipal-bond market started 2011 with many “extreme trends,” points out Chris Shayne (left), CFA and senior market strategist of the BondDesk Group: Meredith Whitney’s comments on “60 Minutes” last December triggered a massive increase in retail demand for individual muni bonds during January and February and concurrent and unprecedented outflows in municipal bond funds.
While yields were consistently low in 2011, these rose temporarily (in January and February) due to massive fund redemptions, Shayne points out.
Otherwise, yields were the lower and spreads were higher than any point since January 2006, with the exception of the economic crisis of ‘08-’09, partially due to historically low Treasury yields and increased concerns about credit risk.
This coming year, says Shayne, should be a solid year for retail investors of muni bonds. “While yields appear to be near a bottom, they is a slim chance they could fall further,” he explained.
The demand for munis is likely to remain strong, since investors appear willing to purchase individual muni bonds, the analyst notes. It seems that equity-market fatigue has pushed more retail investors into munis in spite of limited returns, a trend expected to continue in 2012.
With the biggest economic problems now centered in Europe, only minor impacts are expected to be felt on the muni market,” the analyst said in a recent report.
As a result, investors should consider a buy-and-hold strategy for short- to medium-term, investment-grade munis. They can also build a bond ladder to take advantage of potential rate increases.
“Stick with individual bonds vs. funds–which is a good defense position to be in if rates rise,” Shayne concluded about municipals.
The past 12 months have been tumultuous for retail corporate bond investors, as numerous macroeconomic events (such as the European debt crisis) roiled the credit markets, according to BondDesk.
As with munis, investors can expect a solid year for corporate bonds, as yields appear to have rebounded from 2011 bottom, notes Shayne. While they could fall again if the European crisis permanently fades, such a scenario seems unlikely, and the retail demand for corporate bonds is expected to remain strong, he shares.
“Opportunistic investors will continue to capitalize on elevated financial yields; equity-market fatigue will continue to push more retail investors into corporates’ and problems in Europe likely to persist, which may trigger some domestic corporate defaults for firms with heavy exposure to Europe,” Shayne explained.
“Overall, there are no reasons to expect major problems in the U.S. corporate bond market,” he concluded, despite a weak domestic economy.
A strategy that focuses on buying and holding short- to medium-term investment grade corporate bonds and opportunistically investing in financial bonds, if clients can afford to take some risk in their portfolios, is suggested. And avoiding bonds with direct exposure to European economy is also important, according to Shayne.
In the corporate-bond world, “There has been an increase in repricing of risk as spreads have become more volatile and liquidity has become very thin, as dealers have committed less of their balance sheet to this market,” according to James Camp, CFA and managing director of fixed income at Eagle Asset Management.
As a result, the eurozone crisis is likely to exacerbate this trend as financials are avoided.
In terms of municipals, “We see markedly improving credit with attractive pricing, especially given lower issuance and likely tax changes surrounding the 2012 elections,” Camp said. “There is an overall theme of capital preservation in a deflating environment,” he concluded.
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