Bond-Market Outlook 2012

January 31, 2012

Kathy A. Jones
Vice President, Fixed Income Strategist, Schwab Center for Financial Research

Avoiding risk was rewarding in 2011

Last year was a good one for bond investors. The total return for the Barclays Aggregate Bond Index was 7.8%, led by strong gains in US Treasuries. In fact, last year's common theme was the outperformance of high-quality bonds over riskier bonds. Longer-term Treasuries—those maturing in more than 20 years—returned more than 30%. Municipal bonds also performed well, producing double-digit returns despite concerns about the finances of state and local governments.

In the corporate bond sector, bonds in traditionally safe sectors such as utilities outperformed riskier financial-sector bonds. Meanwhile, high-yield bonds produced a more modest 5.0% return. It was a year in which avoiding risk was rewarded. Investors sought relative safety and quality amid uncertainty about the global economy and stock-market volatility.

Barclays Capital Bond Sectors—Annual Total Returns

Source: Barclays Capital, as of December 30, 2011. The US Aggregate, US TIPS, US Corporate High Yield, Global Emerging Markets, Global Aggregate ex-USD, Municipal, US Corporate (Investment Grade) and US Treasury categories are represented by the Barclays Capital US Aggregate Bond, Barclays Capital US Treasury Inflation-Protected Securities (TIPS) Bond, Barclays Capital US Corporate High-Yield Bond, Barclays Capital Global Emerging Markets Bond, Barclays Capital Global Aggregate ex-USD Bond, Barclays Capital Municipal Bond, Barclays Capital U.S. Corporate Bond, and Barclays Capital U.S. Treasury Bond Indices, respectively. Please see disclosures for definitions of each index.

At the start of 2012, investors appear to remain risk-averse. Ten-year Treasury yields remain near 40-year lows (less than 2%) amid signs of slowing global growth, concerns the impact the European debt crisis may have on the global banking system and easing inflation pressures. We expect these factors will keep interest rates low the first part of the year. The index of leading indicators compiled by the Organisation for Economic Co-operation and Development (OECD) suggests that global growth is likely to continue to slow over the next few months, led by weakness in Europe and slowdown in emerging-market countries.

OECD Composite Leading Indicator Versus Real US Gross Domestic Product

Note: OECD's work is based on continued monitoring of events in member countries as well as outside the OECD area, and includes regular projections of short and medium-term economic developments. Member countries include 25 European countries plus Australia, Canada, Chile, Israel, Japan, Korea, Mexico, New Zealand and the United States. Source: The OECD and St. Louis Federal Reserve.The OECD Composite Leading Indicator shown is for the OECD Total (covering 34 member countries), as of January 4, 2012. Real GDP represented by real gross domestic product, percent change from year-ago, quarterly and seasonally adjusted annual rate.

We believe the United States is likely to avoid recession, but slower growth abroad may limit domestic growth. Exports have been a bright spot for the US economy in recent years, accounting for greater than 12% of GDP in 2011, the highest level in a decade. But the growth rate in exports has slowed markedly the past few months from a year-over-year rate of 20% to about 10%, and the trade deficit has widened. In fact, exports posted monthly declines late last year. This slowdown is a factor worth watching.

The ongoing European debt crisis has been a contributing factor to the general trend away from risky investments. Debt concerns have spread from smaller countries such as Portugal, Ireland and Greece to larger countries such as Italy and Spain, pushing up long-term interest rates. Nine European countries had their debt downgraded by Standard and Poor's in mid-January, and European banks holding sovereign bonds are also at risk of downgrades.

While the problems appear daunting, there are positive signs on the horizon. The European Central Bank recently increased liquidity in the banking sector by offering three-year funding at very low interest rates, potentially helping ease pressure on the banks and on governments issuing debt. In addition, European officials appear to be moving towards a plan for greater fiscal union which we believe may ease the crisis.

Federal Reserve outlook

We expect the Fed to keep short-term interest rates near zero in 2012. In addition to slow economic growth and risks from Europe, unemployment remains high at 8.5% and inflation pressures are easing. The recent consumer price index report indicated that overall inflation has edged down to 3.0% while the core rate (excluding food and energy) has slipped back to 2.0%.

Moreover, inflation expectations are easing as well. The expected inflation rate—derived from the difference between 10-year Treasury yields and Treasury inflation-protected securities (TIPS)—has edged down to about 2% in recent months.

The Fed will begin to publish long-term interest-rate forecasts this year, in keeping with its recent trend towards greater openness. The Fed has been quick to point out that these forecasts are not promises or pledges, but rather just the best reflection of its judgment. We expect the forecasts to indicate that the Fed expects rates to stay low into next year. In addition, the Fed's "Operation Twist," aimed at holding down long-term rates, is not expected to be completed until the middle of next year. Finally, we wouldn't rule out another round of quantitative easing by the Fed later this year.

Duration strategy: aim for neutral

Having made the case for interest rates to remain low in the early part of 2012, we nonetheless recognize that at some point, rates are likely to rise. After all, it would be difficult for rates to move much lower from current levels. Therefore, we think it's wise to rebalance your portfolio on a regular basis—especially after a year of such strong performance in the fixed income markets. In an overall portfolio asset allocation, when the value of one asset class rises, it may be time to reduce exposure to that class to bring it back in line with your original target allocation.

One major component of a fixed income portfolio to assess is duration risk. Duration measures the sensitivity a bond has to a change in interest rates. It's not the same as a bond's maturity, but longer-term bonds are typically more sensitive to interest rate changes than short-term bonds. For investors concerned about the risk of rising rates, it may make sense to reduce exposure to longer-duration bonds, particularly if prices have risen substantially. However, this will most likely result in lower current income from the bond portfolio for an extended period of time.

An alternative for investors who expect inflation to rise would be to consider using TIPS for the longer-duration holdings. The principal value of TIPS adjusts with an inflation index, providing some principal protection against an inflation-led rise in rates.

For many investors, we believe bond ladders, where maturities are divided up evenly over a period of years, can be a good way to avoid trying to time the interest-rate cycle. If interest rates begin to rise, then the proceeds from maturing short-term bonds can be reinvested at higher rates, mitigating some of the negative impact of rising rates on the overall portfolio. Bond ladders are designed to result in a neutral duration—one that's not excessively short or long.

A benchmark to use for duration might be the Barclay's Aggregate Bond Index, which currently has a duration of 4.6 years. A portfolio with much shorter duration risks losing out on current income and the compounding of earned interest. A portfolio with much longer duration is likely to be susceptible to volatility when rates rise. When holding longer-term bonds in a ladder or any portfolio, we suggest the longer-maturity bonds be higher-quality (lower credit risk) bonds as a way to help mitigate some of the risks.

Credit: take risk cautiously

Credit risk is the second major factor to reassess in a fixed income portfolio. In a slow-growth, high-risk environment, we believe investors shouldn't reach too far for yield by substantially reducing the credit quality of the bonds they hold. A core portfolio of investment-grade corporate or muni bonds may make sense for many investors. When adding riskier bonds for more yield, it's important to make sure the extra yield adequately compensates for the credit risk. We believe aggressive income bonds, such as high-yield or emerging-market bonds, should be limited to no more than 10% of a fixed income portfolio.

Investment-grade corporate bonds performed well last year, but yields didn't fall as fast as Treasury yields. In a slow-growth economy, the spread between corporate and Treasury bond yields may widen, but overall the risk/reward outlook for investment-grade bonds appears attractive to us. US corporations generally have higher levels of cash and lower leverage than they did a few years ago.

It's important to maintain diversification among sectors. Financial-sector bonds have underperformed other sectors over the past year and therefore carry higher yields. Bank and finance companies are at risk if the economy slows, but in general, the US banking sector has made progress the past few years raising capital and reducing leverage. Since yields are significantly higher for bank bonds, investors with higher risk tolerance could look at this sector to try to selectively increase yield in a portfolio.

High-yield corporate bonds can also potentially add yield to a portfolio for investors with higher risk tolerance. Last year the sector was quite volatile while returns lagged higher-quality sectors. However, default rates remain low, and the current average yield in the 7% to 8% region provides some compensation for the added risk. We suggest limiting aggressive income bonds to no more than 10% of the portfolio.

Municipal bonds rebounded sharply from their steep decline in late 2010, but the yield ratio relative to comparable Treasuries is still greater than 100% in most cases. We think the relatively high yields on municipals reflect worries about budget strains as well as uncertainty about tax policy longer term. However, while we believe municipalities are likely to remain under stress in the current environment, we don't anticipate a significant rise in defaults or bankruptcies. Many municipalities are taking the steps needed to address strained budgets by cutting spending and raising revenues. Consider bonds backed by stable sources of revenue or state general obligation bonds where there are legal protections for bond holders.

International developed-market bonds remain volatile due to Europe's debt crisis. Some allocation to international bonds or bond funds can help provide diversification for a portfolio. Historically, they tend to perform best when the US dollar is declining. In the current environment, currency risks appear to be high relative to yields offered, but longer term, a modest allocation may make sense.

Emerging-market bonds underperformed most other bond-market sectors last year as investors pulled back from riskier assets. We believe the underlying fundamental factors for emerging markets are generally good. Many emerging-market countries are experiencing rising growth and declining debt loads. However, emerging-market countries are susceptible to slowing global growth, and tend to be less liquid and more volatile than developed-market bonds. As long as investors remain risk-averse, this sector is likely to be volatile and returns may be limited.

The start of a new year can be a good time to rebalance your investment portfolio. For fixed income investors, it's particularly important to take a second look at the bonds you hold after the strong gains in the bond market last year. In 2012, we think investment returns for bonds are likely to be driven by income earned rather than gains in price. It's a good time to review your portfolio with your Schwab advisor.