Search for Income | Second Quarter 2014

Yield Compression

Bond yields declined further over the second quarter of 2014 continuing the descent that began at the start of 2014. By mid-year 2014, the 10-year Treasury yield was sitting just above 2.5%, the low end of a one-year range. Bond market strength has been broad-based in 2014. While prices increased, and yields fell, for top quality Treasury securities, yields on many segments of the bond market declined even more [Figure 1]. The low yield environment that is challenging income-seeking investors persists.

Not only are yields low across the bond market but the threat of price declines associated with rising interest rates also lingers. Higher valuations resulting from bond market strength, rising inflation, and the gradual approach of a Federal Reserve (Fed) interest rate hike in 2015 may work to push interest rates higher and prices of income-producing investments lower. Although a Fed rate hike likely remains a late 2015 occurrence, current bond market pricing remains far away from levels that have historically accompanied Fed rate hikes.

Caution is therefore warranted as investors assess income-producing investments. Higher valuations, lower yields, and the possibility of rising interest rates suggest total returns will be much lower. For bond price gains to continue, we believe a renewed bout of economic weakness, or a signal from the Fed that the first rate hike will take place later than the indicated late 2015 timeline, is necessary but we view neither of these as likely.

The decline in bond yields over the first half of 2014 has complicated the task for income-seeking investors. We believe corporate bond sectors, such as high-yield bonds, have historically held up better against rising interest rates and remain our focus. An expanding U.S. economy should help support the ability of companies repay debt obligations and may help support prices in a rising rate environment. Although yields are low, we believe these sectors may be a way to manage the difficult yield environment.

Among high-quality bonds, we believe municipal bonds represent a better longer-term opportunity. Municipal bond valuations improved notably over the first half of 2014. However, when viewed over a long-term context, municipal valuations remain attractive 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 market debt (EMD)

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