Search for Income | First Quarter 2014

The Yield Decline Resumes

Bond yields resumed a downward trend during the first quarter of 2014. After rising for much of 2013, better valuations, slower-than-expected first quarter 2014 economic activity, China growth concerns, and geopolitical fears over Ukraine-Russia helped push prices higher and yields lower, led by longer-term securities. Income-seeking investors can take solace, however, in yields remaining near two-year highs for many high-quality bond sectors. On the negative side, the average yield of high-yield bonds, a key potential income-producing sector, declined again [Please see full publication link below for Figure 1].

We expected 2014 to be gentler to bond investors, but the strength witnessed over the first quarter and early into the second quarter appears unsustainable and may slow or reverse. We still expect roughly flat total returns for high-quality bonds in 2014, with better economic growth the primary driver of higher bond yields and flat returns. As economic growth accelerates and the policymakers at the Federal Reserve (Fed) reduce its direct impact on the bond market in 2014, higher interest rates will likely be the result. In this environment, high-quality bond returns may be flat. The bond market’s strong start to 2014 increases the likelihood of a low single-digit total return for the broad bond market, but investors are still facing a very low return environment. The twin forces that drove yields higher in 2013 — a reduction in Fed bond purchases and stronger economic growth — could likely resume pushing high-quality bond yields higher and prices lower even if at a slow pace. Therefore, income-seeking investors should be aware of the possibility of weaker prices in the pursuit of income.

The decline in bond yields over the first quarter of 2014 has complicated the task for income-seeking investors. Corporate bond sectors, such as high-yield bonds, have historically held up better against rising interest rates and they remain our focus. In 2013 for example, high-yield bonds and bank loans posted positive returns in contrast with declines across all other bond sectors. An expanding U.S. and global economy should help support the ability of companies to repay debt obligations and may help support prices in a rising rate environment.

Among high-quality bonds, municipal bonds represent a better longer-term opportunity. Municipal bond valuations remain attractive relative to Treasuries and may provide a buffer against rising interest rates and an attractive after-tax yield.

Among income-producing sectors, high-yield bonds stand out as one of our favorite investments. In general, we prefer to look domestically for income-generating investments given the more favorable economic backdrop, which should continue to support credit quality. Currently, we believe the following ideas may help meet investor income needs:

• High-yield bonds (taxable and tax-free)
• Bank loans (floating rate funds)
• Preferred stocks
• Investment-grade corporate bonds (intermediate- and long-term)
• Emerging market debt (EMD)

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