That was so 2016 and 2017

On the heels of two good years in the bond market, the best days for fixed income are likely behind us. 2016 produced strong returns in most sectors, especially high yield corporate bonds, which generated double digit gains. 2017 was more of the same driven by strong global demand and scarce inflation. Returns will likely struggle to match that pace in 2018 based on a lower starting point for yields and risk premiums, expectations for low inflation and a less accommodating US Federal Reserve, and no extra risk premium for potential negative surprises. The temptation is to extrapolate recent returns and suggest another good year for bonds, but our analysis suggests something less.

The lower starting point in bond yields reduces the total return opportunity in fixed income. Government bond yields and risk premiums for non-government bonds are historically low. Taken together, yields for most sectors of the bond market offer little protection from rising rates, higher defaults, or exogenous shocks. Low starting yields mean less cushion for being wrong and less upside for being right.

Lower yields mean less return opportunity

Source: Bloomberg/Barclays.

Another reason to exercise caution is that investor expectations may have swung too far - from being overly fearful of the Fed and inflation when bond yields were higher, to overly sanguine about the Fed and inflation at lower yields. In fact, bond managers have been wrongly calling for higher rates since the global financial crisis, pointing to ultra-low yields globally and massive stimulus by the major central banks. Yields could only go up, right? Wrong! Yields stayed lower for far longer than most expected, and the Fed was as misguided as anyone in their forecasts for short-term interest rates. But as global financial conditions improved and central banks became less accommodative, investors show little concern that the environment might be changing. They are not fearful of an acceleration in rate hikes or inflation. Simple but sage advice when investing: be greedy when others are fearful, and fearful when others are greedy.

Help wanted: Good interest rate forecaster

2017* - Represents long-term dot as of: 12/18/2013 and the actual Fed Funds Rates as of 12/13/2017

Source: FOMC.

Related, too much money may be chasing bonds at historically low yields. Strong global demand for income has caused some investors to reach for yield in low quality corporate bonds, frontier markets, and other less traditional investments. Many have not experienced a Fed tightening cycle or credit downturn (2015 doesn't count as a credit downturn - the sell-off in corporate bonds was very concentrated in commodity-sensitive industries). Some call this imbalance a bubble, which may be overly dramatic, but the point is 'crowded trades' can exaggerate price moves as investors enter and exit positions en masse.

Inflation is the missing puzzle piece

In recent years, the cumulative effect of massive stimulus by central banks helped restore and improve financial conditions, create jobs, and generate strong market returns. Surprisingly, though, core inflation has been a no-show. One dramatic example of missing inflation is modest US wage gains during a period of significant decline in the unemployment rate. Inflation is so overdue that many are now questioning if this is a structural change, rather than temporary. In fact, outgoing Fed Chair Janet Yellen commented before her departure that for the first time perhaps low inflation was not transitory at all. If true - and more and more are subscribing to this possibility - low yields may be justified. If not true, the market may be thinking it is different this time, when in fact, it is not. The jury is still out.

Lower unemployment & lower inflation sustainable?

Source: Bureau of Labor Statistics.

Duck, duck, goose-egg!

2018 will likely produce different results for fixed income investors than the prior two years. The risk reward trade-off appears less compelling for high- and low-quality bonds. Even a modest rise in interest rates of 0.50% would generate price losses for US treasuries that more than wipe out income return, given coupons are so low as a starting point. At the other end of the risk spectrum, high yield corporate bonds start 2018 with average yields around 5.5%, or about 3.5% more than US treasuries. The yield premium compensates investors for about a 1% default rate. Our internal research analysts forecast defaults between 3-4%. In other words, investors are not being adequately compensated for expected default risk, whereas we prefer to be compensated for expected defaults, plus extra risk premium for potential negative surprises. When investors are not compensated for taking risk, they should not take those risks!

Back-to-back years of strong returns in fixed income are a tall order, especially at current valuations. The upshot for 2018 may seem unexciting, but prudent bond strategies still seem likely to outperform cash. Our fixed income playbook calls for less interest rate and credit risk, and more diversification. Stay invested but temper your expectations, turn down risk, and wait for better days and higher yields.

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