Last year was a pretty good year for bond investors. The Barclays U.S. Aggregate bond index, which tracks Treasuries and other U.S. investment-grade bonds, earned about 5.9% in 2014, up from a 2% loss in 2013.
So what is the outlook for bonds in 2015? Some bond analysts are predicting another solid year for the bond market, though probably not as strong as last year was.
Will the Fed Raise Rates — and When?
One of the biggest unknowns that will affect bonds this year is whether or not the Federal Reserve will start raising interest rates from near-zero levels — and if so, when interest rate hikes will begin. The Fed is generally expected to raise the target federal funds rate by one-quarter or one-half percentage point as early as this summer, but probably no later than the end of the year.
In anticipation of this rate hike, short-term debt could sell off, raising these yields. (As bond yields rise, their prices fall, and vice-versa.) It is less certain, however, whether or not long-term debt will follow this pattern. Weak inflation, slow global growth and worldwide demand for U.S. assets could hold down a rise in long-term bond yields.
The uncertain outlook for global growth, concerns about deflation in Europe and falling oil prices have driven many investors into ultra-safe U.S. government bonds during the early part of this year. The International Monetary Fund (IMF) has lowered its forecasts for global growth both this year and next year by 0.3 percentage points to 3.5% and 3.7%, respectively. Meanwhile, crude oil prices are down more than fifty percent since last summer.
What About QE in Europe?
Another factor that will probably affect bonds this year is the recent announcement by the European Central Bank (ECB) that it will start a bond-buying program in March that will be similar to the Federal Reserve’s recently concluded Quantitative Easing (QE) program. Through the program, the ECB will buy sixty billion euros worth of bonds a month until at least September 2016 — or a total of 1.1 trillion euros in bond purchases — in order to combat stagnation and ultralow inflation in the Eurozone. The goal of the program is to raise the inflation rate in the Eurozone up to a target of 2% and, in the process, revive the stagnant European economy.
The scope of the ECB’s bond-buying program is larger than many analysts expected, and was welcome news when it was announced on January 22. In a Wall Street Journal article announcing the program on that day, one European economist said that the ECB “surpassed expectations in key aspects of its expanded asset-purchase program, including the scale of the planned buying and its ‘open-ended’ nature.”
After the U.S. Federal Reserve’s QE program, yields on U.S. government debt fell so low that many investors turned to equities to boost returns. Anticipation of the ECB’s bond-buying move sent many Eurozone government bond yields to record low levels in early January. Upon the announcement of the program, the prices of government bonds issued by many European nations (including Germany, Spain, Italy, the U.K. and Switzerland) jumped, pushing yields even lower, and the yield on 10-year U.S. Treasuries fell to 1.78%. While low, the yields on U.S. government bonds are still attractive in comparison to most European government bonds.
In a Wall Street Journal article published before the announcement of the ECB program, the head of bond trading at a prominent New York City investment firm said he expected a rally in U.S. Treasuries if the ECB announced a significantly large bond-buying program of at least one trillion euros.
Meanwhile, in an interview on CNBC, a bond strategist said he thinks global disinflation and even outright deflation, along with volatility in the equity markets, will make bonds attractive this year. This “has caused a price rally in perceived safe-have bonds such as U.S. Treasuries,” he said. Of course, the ECB’s bond-buying program is designed to reverse the disinflationary trend in Europe.
Bond Bears Weigh In
The past few years, bond bears have been rampant during the early months of the year. They cautioned that rising inflation and interest rates were inevitable and bonds would take a serious hit during the rest of the year.
The reality has been far different, as inflation has failed to materialize and rates have remained low. One reason for this has been the slow economic recovery. If the recovery had been more robust, like typical post-recession recoveries, bond yields would probably have been in the 4%-5% percent range, instead of closer to 2%.
Still, the yield on U.S. Treasuries remains higher than yields on most other government bonds. As the president of one investment firm put it in an interview with the New York Times: “Who would want 2% on our 10-year? Everyone who is outside the U.S., that’s who.”
In the same article, a fixed-income specialist said we could again see a link between 10-year Treasury rates and nominal GDP (or GDP not adjusted for inflation) this year. “What makes this debate more complicated [are] the complexities of what’s happening on the global stage,” he said. He pointed out that investors in search of higher yields can turn to municipal bonds, bank loans and corporate bonds with lower credit quality (including junk bonds). Of course, there may also be more risk with these types of bonds.
One possible option for reducing risk when investing in bonds is unconstrained bond funds. These offer a high level of flexibility because they are not restricted to investing just in Treasuries or corporate bonds, or in any particular region or country. However, they might not be right for you if you want to track your investment’s performance against a certain benchmark.
Of course, no one has a crystal ball to know exactly what lies ahead for the bond market — or any other investment market — in the year to come. That is why it is usually a good idea to diversify your portfolio with the right mix of bonds, stocks and cash equivalents. You should talk to an investment advisor for more advice about the right investing strategies for you based on your investment goals and time horizon.