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2015 Bond Scoresheet

U.S. fixed income has been lackluster so far this year as rate-hike worries have been offset by periodic flights to safety, but high yield should continue to outperform.

2015 Bond Scoresheet

Dave Sekera: Returns across most domestic fixed-income instruments have been relatively lackluster this year. For example, the Morningstar Core Bond Index, which is our broadest measure of the fixed-income universe, has only risen less than one percent through the beginning of August.

After generally declining in 2014, long-term interest rates have struggled to find a consistent direction this year and have vacillated within a 1% trading range. Interest rates have been bound between the expectation that the Fed would begin to raise its federal funds rates in the second half of this year. That, in turn, has put upward pressure on Treasury yields; but this upward pressure has been offset by global and domestic economic concerns, which have then driven different bouts of risk-off and flight-to-safety portfolio re-allocations.

In the corporate-bond sector, both the investment-grade and high-yield sectors have been impacted by the precipitous decline in raw-material and oil prices. As commodity prices have fallen, the corporate-bond market is pricing in greater credit and default risk in the basic-materials and energy sectors, and the credit spreads in both of those sectors have widened appreciably.

Within the Morningstar Corporate Bond Index, the basic-materials sector accounts for about 5.5% of the index, and the energy sector accounts for 10%. As these sectors have been under significant pressure, the average spread of the overall index has widened 22 basis points this year. That widening credit spread of the overall index has offset much of the yield carry generated by corporate bonds, and the total return for the investment-grade index, thus far, is essentially zero percent.

In the high-yield sector, the Bank of America Merrill Lynch US High Yield Index has risen 1.72% for the year. At the end of last year, we stated our case on why we thought high yield would outperform investment-grade this year, and essentially the main points of our investment thesis remain unchanged.

Following the release of the second-quarter GDP growth rate, Bob Johnson, Morningstar's director of economic analysis, reaffirmed his projection for the full-year 2015 GDP growth rate in the U.S. to range between 2.0% and 2.5%. In order to reach his full-year economic forecast, growth in the U.S. would need to average about 2.7% for the second half of the year. While depressed prices of commodities will impair the credit quality of the companies in those sectors and we may see a few isolated bankruptcies, this level of economic growth should be enough to generally hold down the overall default rate. That, in turn, will support the high-yield market and credit spreads within the high-yield market.

In addition, the Fed still appears to be on course to begin raising short-term rates later this year, and that may have the knock-on effect of pushing long-term rates higher. As such, with the expectation that default rates will remain relatively low and interest rates appear poised to head higher, the high-yield sector, with its lower duration and higher credit spread, should continue to outperform the investment-grade sector in the second half of the year.

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