Global economic growth fears led to divergent changes in bond yields over the third quarter of 2014 and into the fourth quarter. A weakening European economy–which is on the brink of its third recession since 2008–and unrest in Ukraine, the Middle East, and Hong Kong, along with a decline in oil prices, boosted demand for high-quality bonds. Treasury yields fell to 15-month lows, while lower-rated and more economically sensitive sectors, such as high-yield bonds, suffered price declines amid fear-induced selling. The mixed response led to differing yield changes over the third quarter of 2014.

On a positive note, bond prices were driven by nonfundamental factors, creating potential opportunities for yield-seeking investors. The domestic economy continues to show signs of expansion with third quarter economic growth on track to rise by approximately 3%, adding to the 4%-plus rate of the second quarter of 2014. Jobs data have improved and many reports have met or exceeded expectations amid the negative headlines. The strength of the U.S. dollar over the third quarter has pressured inflation expectations lower, which may keep the Federal Reserve (Fed) on hold for longer–a longer-term positive for lower-rated bonds.

Yields on high-yield bonds are near one-year highs but continue to be supported by good credit quality metrics and a low-default environment. We expect third quarter corporate earnings reporting season, which began in mid-October 2014, to show mid- to high single-digit growth and further bolster the ability of corporate issuers to repay debt. Higher yields and cheaper valuations may provide a window of opportunity for income-seeking investors.

Recent market volatility combined with European economic weakness and a strong dollar may restrain the Fed from raising interest rates in mid-2015. A later start to Fed rate hikes may help keep yields low and support high-quality bond prices. But most high-quality bond sectors have enjoyed very strong performance in 2014 and valuations are high, suggesting that even if interest rates do not rise immediately, longer-term return prospects are still very low.

We continue to suggest caution for many areas of the bond market due to lower yields, strong year-to-date performance, and higher valuations. Although a window of opportunity may have opened in high-yield and bank loans, most segments of the bond market offer limited prospects. A challenging environment still exists for income-seeking investors.

Among high-quality bonds, we believe municipal bonds represent a better longer-term opportunity. Municipal bond valuations improved notably over the first three quarters of 2014. However, when viewed over a long-term context, municipal valuations are on the attractive side relative to Treasuries and may provide a buffer against rising interest rates in addition to an attractive after-tax yield.

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, our ideas for potential income generation are:

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

View the Search for Income | Third Quarter 2014.

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