• / Free eNewsletters & Magazine
  • / My Account
Home>CLS: Bonds’ Role Within Portfolios, Expected Bond Yields, and Sales in Bond Market

Related Content

  1. Videos
  2. Articles
  1. How to Invest in a Slow-Growth World

    Panelists at the Morningstar Individual Investor Conference discuss how to position for profit amid anemic growth, energy volatility, the threat of inflation, and extraordinary central bank activity.

  2. Top Investment Ideas for Retirement

    Retirement Readiness Bootcamp Part 5: Morningstar strategists share their top fund, ETF, and dividend stock picks to fill your retirement portfolio.

  3. Christine Benz's 6-Step Portfolio Checkup

    Morningstar's director of personal finance outlines how to gauge your portfolio's viability, evaluate your allocation, troubleshoot risk factors, and more in this special Web seminar presentation.

  4. Unearthing Value in Bonds

    Panel discussion: TCW's Laird Landmann, Loomis Sayles' Elaine Stokes, and Gibson Smith of Janus explore potential areas of opportunity in the credit markets, the prospect of a liquidity crisis, and more.

CLS: Bonds’ Role Within Portfolios, Expected Bond Yields, and Sales in Bond Market

02/11/2016

Week in Review
Volatility remained prevalent in the equity markets last week, as did the increased correlation between the price of oil and stocks. Oil was down more than 8% for the week, dragging stock prices lower with it. Large-cap U.S. stocks fell more than 3%. International stocks held up better but were still negative. Developed international stocks were down 1.5%, with emerging market stocks performing best, down only 0.4%. Bonds were positive during the week, with the Aggregate Bond Index up 0.2%.

The big story from the week’s economic data came in Friday’s payroll report. The U.S. economy added 151,000 new jobs in December, substantially below expectations. November’s strong jobs number was also revised lower. Though the unemployment rate fell to 4.9%, the focus seemed to be on the hourly earnings data that came in higher than expected.

How Do You Like Me Now?
In May 2013, the then-Chairman of the Federal Reserve (Fed) Ben Bernanke announced the intent to begin withdrawing an extraordinary policy tool known as quantitative easing (the purchase of Treasury bonds by the Fed for the purpose of suppressing interest rates). The market’s subsequent negative reaction, and the extreme sello in fixed-income assets became known as the “Taper Tantrum.” Since then, portfolio managers at CLS have had countless conversations with advisors concerned about rising rates. Market pundits called for the dawn of a new bond bear market. Investors wanted to sell out of their bond allocations completely.

Fast forward nearly three years to a length of time that is actually appropriate for a review of performance, rather than the typical focus on monthly or quarterly returns. How did bonds do versus equities? How was investor performance for those who ignored the noise and stayed the course versus those who got caught up in the hype?

As it turns out, the bond market did not implode as many were predicting, and it has actually outperformed the stock market! Had investors with moderate risk tolerances and approximate risk budgets of 60 strayed from their plans and moved their bond allocations to cash, they would have earned a cumulative return of about 3.5%. On the other hand, an investor who was able to control his or her emotions and stay true to his or her investment plan would have earned a cumulative return of nearly 7%. This amounts to an outperformance of nearly 3.5%, and it was done with less risk.

So, what is the moral of this story? Bonds remain an invaluable tool for investors to diversify their portfolios. Stay balanced!

Where Can Yields Go From Here?
Last December, the Fed initiated a rate hike for the  first time in nine years. Despite this move, Treasury yields are the lowest they’ve been in 12 months, and are considered low relative to historical levels. A question on the mind of many investors is “where will yields go from here?”

At this time, both the market and Fed predict the benchmark interest rate will be higher by 2017. There is, however, a large gap in expectations of how much higher it will be. As of their last policy meeting, Federal Open Market Committee (FOMC) members published a median estimate of four rate hikes for 2016. On the other hand, the market indicates investors believe there will be only one hike based on the current pricing of Fed Fund Futures. At CLS, we believe the number of rate hikes will likely be somewhere between what the market and the Fed are expecting.

Regardless of how many times the Fed increases rates this year, there are a few reasons to believe interest rates (especially on the long end of the curve) will be capped. Heightened volatility in the stock market causes a flight to quality as investors seek the relative safety of Treasuries. Other central banks around the globe continue to ease, with more and more adopting negative interest rate policies. Expectations for growth and inflation remain low. And finally, the Treasury announced a reduction in the issuance of longer-term notes and bonds in favor of Treasury bills with a maturity of one year or less. This reduction in supply on the long end of the curve can serve to boost prices and therefore lower yields.

What’s on Sale in Fixed Income?
In our January Monthly Market Review, Chief Investment Officer Rusty Vanneman, CFA, discussed our current outlook and portfolio positioning. In this discussion he made a simple statement, “CLS likes to buy stuff  on sale.” Value investing, unlike so many other “investment strategies” and fads, has stood the test of time. So the question is: Where does CLS see value in fixed income? Or, to put it like Rusty did, what part of the bond market is on sale?

By now the average investor is well aware of the far-reaching impacts of low oil prices on other asset classes. A great example of this is the high-yield bond market. As prices on bonds issued by energy companies fell rapidly, the negative sentiment was transmitted to the broad high- yield market. The result of this contagion effect is that the high- yield market appears priced as if a recession is imminent, which we do not believe is the case.

Inflation-linked bonds are another area that looks very cheap. In fact, since they were first issued by the Treasury in 1997, 10-year TIPS have only been cheaper than they are right now 6% of the time. The current price on TIPS implies inflation will only average 1.38% over the next 10 years, something that has not happened during the last 40 years.

Finally, heightened market volatility, concerns regarding the Chinese economy, and fears of tightening monetary policy in the U.S. have weighed on emerging market stocks and bonds alike. Dollar-denominated debt raised by emerging market issuers has only been cheaper 7% of the time over the last 10 years.

Each of the above fixed-income segments looks attractively priced relative to both the bond market as a whole and to its own price history. If the bond market had a bargain bin, you would  find these assets there. That makes them attractive to us. CLS portfolios either currently hold large positions in these segments or are looking to increase exposure in the near term.

 

The S&P 500® Index is an unmanaged composite of 500-large capitalization companies. This index is widely used by professional investors as a performance benchmark for large cap stocks. The Russell 3000 Index is an unmanaged index considered representative of the U.S. stock market. The index is composed of the 3,000 largest U.S. stocks. The Russell 2000® is an index comprised of the 2,000 smallest companies on the Russell 3000 list and offers investors access to small-cap companies. It is a widely recognized indicator of small capitalization company performance. The MSCI EAFE International Index is a composite index which tracks performance of international equity securities in 21 developed countries in Europe, Australia, Asia, and the Far East. The MSCI All-Countries World Index, excluding U.S. (ACWI ex US) is an index considered representative of stock markets of developed and emerging markets, excluding those of the US. The Barclay’s Capital U.S. Aggregate Bond® Index measures the performance of the total United States investment-grade bond market. The Barclay’s Capital 1-3 Month U.S. Treasury Bill® Index includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. The Equity Baseline (EBP) is a blended index comprised of 60% domestic equity (represented by the Russell 3000 Index) and 40% international equity (represented by the MSCI ACWI ex US Index), rebalanced daily. An index is an unmanaged group of stocks considered to be representative of different segments of the stock market in general. You cannot invest directly in an index.

The views expressed herein are exclusively those of CLS Investments, LLC (CLS), and are not meant as investment advice and are subject to change. CLS is not affliated with any companies listed above. No part of this report may be reproduced in any manner without the express written permission of CLS. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. This material does not constitute any representation as to the suitability or appropriateness of any security, financial product or instrument. CLS is not making any comment as to the suitability of any funds mentioned, or any investment product for use in any portfolio. There is no guarantee that investment in any program or strategy discussed herein will be profitable or will not incur loss. This information is prepared for general information only. It does not have regard to the specific investment objectives,  financial situation, and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that security values may  fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance. Individual client accounts may vary. Investing in any security involves certain non-diversifiable risks including, but not limited to, market risk, interest-rate risk, inflation risk, and event risk. These risks are in addition to any specific, or diversifiable, risks associated with particular investment styles or strategies.

Fixed Income is an investment style designed to return income on a periodic basis. Generally, fixed income strategies invest in bonds, real estate, loans, and other types of debt instruments. Diversi able risks associated with fixed income investing include, but are not limited to, opportunity risk, credit risk, reinvestment risk, and call risk.

1128-CLS-2/9/2016

 

©2017 Morningstar Advisor. All right reserved.