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‘No Fooling, Good Quarter for Bonds’: LPL Strategist

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A funny thing happened while fixed-income aficionados were following the departure of PIMCO CEO Mohamed El-Erian and the reported breakdown in his relationship with PIMCO founder Bill Gross (not to mention Janet Yellen’s new role as chairwoman of the Federal Reserve): Bonds had a good quarter.

Click to enlarge. Source: LPL Financial Research, Bloomberg, 3/31/14“Bonds actually matched the performance of stocks over the first quarter of 2014, contrary to many expectations at the start of the year,” said LPL Financial (LPLA) research strategist Anthony Valeri, CFA, in his report “No Fooling, Good Quarter for Bonds,” released Wednesday.

That’s right. The Barclays Aggregate Bond Index finished the quarter with a 1.8% total return, which is equal to that of the S&P 500 Index after reinvestment of dividends, according to Valeri.

“Bond prices rose across the board following a difficult 2013, and yields fell, with the 10-year Treasury yield closing the first quarter 0.3% lower,” he explained. “Stocks ran behind bonds for much of the first quarter, but a strong day for stocks on the last day of the quarter closed the gap.”

Preferred-stock bonds led the pack with gains of 6.5% in the first quarter, followed by municipal high-yields at 5.9%, according to LPL Research.

Emerging market debt rose 3.5%, muni bonds 3.3%, unhedged foreign bonds 3.2% and high-yield corporates 3.0%.

“Lower-rated, more economically sensitive sectors such as high-yield bonds shook off the growth uncertainties affecting stocks,” noted Valeri, “as investors focused on a low default environment and a still-strong capability to repay debt obligations.”

What pushed bond returns higher? Weaker economic data, geopolitical uncertainty and a reduction in Federal Reserve bond purchases.

“Investors questioned the ability of the economy to stand on its own given the two factors above and the Fed’s widely anticipated reduction of bond purchases,” the LPL Financial analyst said. “The Fed has steadily reduced its monthly bond purchases by $10 billion at the conclusion of each of its last three meetings, adding to investor nerves and helping to support bond prices.”

That’s the good news.

Q2 Outlook

Valeri points out that the nearly 2% quarterly return for the Barclays Aggregate Bond Index is not a sustainable pace.

“Simple math would put the current pace on track for a high-single-digit return for the full year, a very difficult achievement for a still low yield environment,” he cautioned.

For bond prices to continue to rise and yields to fall, the markets would have to see one or two things happen: Persistent lackluster economic data and a Fed pause in tapering its bond purchases.

Neither scenario is likely.

“We expect economic data to improve and believe the odds of both outcomes above are low,” the LPL report noted. “The Fed has additionally indicated that a reduction in bond purchases will continue, and it is unlikely to alter course absent a significant shift in the economy.”

Still, lower-rated sectors of the fixed-income universe, such as high-yield bonds, should offer yields to buffer the impact of rising rates, Valeri adds. With an average yield spread of 4%, however, high-yield bond prices don’t have much room to improve further, and the LPL Financial fixed-income team expects interest income to be “the primary driver of returns over the balance of 2014.”

Valeri says the 3.5% Treasury-yield level appears to be “an important market signal,” as a drop below that mark would indicate that the bond market sees greater economic concerns.

Overall, Valeri says, bond prices and yields may remain in their longstanding range until May (when more economic information is published). A repeat of the first-quarter performance “is unlikely,” he adds.

“We continue to favor lower-rated bonds,” Valeri stressed. “Although additional price gains for lower-rated bonds may be limited, higher interest income may help deliver a performance edge over the remainder of 2014.”