INSIGHTS

On December 09, 2014

Viewpoints from AAM - The Search for Income – Where Do We Go from Here?

Income investors, starved for yield, have continued the trend of extending maturities and/or purchasing below investment-grade securities in their search for income. Bond funds continue to post net inflows, which is a reversal of the 2013 trend which had $77 billion in bond fund outflows. The Investment Company Institute estimates total bond fund inflows in 2014 of $51 billion (taxable bond inflows of $29 billion and municipal bond inflows of $22 billion). According to Lipper U.S Fund Flow data, investors have added money to U.S. mutual funds that focus on riskier municipal debt in 18 of the last 19 weeks while investment grade funds have had 24 weeks of inflows and high yield bond funds have had inflows for five of the past seven weeks. This flow of funds seems aligned with the fixed income market’s performance thus far in 2014.

Barclays Index Data (Total Return)

* 1/1/14-11/30/14. 

Source: Barclays Capital.  Past performance is not indicative of future results.

­­The search for extra yield goes beyond the United States as rates around the world have fallen on a year-to-date basis. The yield on the 10-year U.S. Treasury on 12/31/2013 was 3.02%, and the consensus analyst estimates were calling for 3.4% by the end of 2014. Now the yield is 2.16% and the estimates are 2.5% by year-end and 3.24% at the end of 2015. There has been an abundance of news this year that helped fuel the flight to safety, but when you look at rates around the globe you see that U.S Treasury yields are compelling to foreign investors. The table below shows the 86 basis point drop in yield this year still leaves the United States above 2% and trails the drop seen across other major sovereigns.

10 year Sovereign Yields

Source: Bloomberg

In the corporate bond market, Medtronic’s recent $17 billion new issuance has pushed sales of corporate bonds in the domestic market past the $1.5 trillion mark for 2014. It appears the lower interest rate environment has companies issuing debt at one of the fastest rates in history. These proceeds continue to be used for mergers and acquisitions (as illustrated by Medtronic’s purchase of Covidien PLC), and share buybacks rather than capital expenditures. In the municipal bond market, state and local governments plan to raise over $18 billion in the next 30 days as the calendar of proposed offerings is one of the largest in years and well above the 2014 average 30-day visible supply of $7.378 billion, according to Bond Buyer. It appears 2014 will likely be one of the best years of performance for both taxable and tax-exempt municipals in the last 20-30 years.

As we look back at the performance across fixed income asset classes in 2014 and begin planning for next year, remember changing demographics in the United States, economic data, geopolitical concerns and Eurozone sovereign rates will all continue to impact fixed income markets. It’s important to understand your client’s risk tolerance, look for opportunities across sectors that may be out of favor and actively manage the duration in their portfolios. We anticipate more volatility in the fixed income markets in 2015 and although we don’t try to predict interest rates, we believe the trend in the future will probably be up. If the Fed decides to raise rates in 2015, the removal of the “considerable time” language may be your first indication that a change is coming. A shift up in short-term rates would add to the flattening trend in the yield curve. Although the yield curve remains positively pitched, it has exhibited a flattening trend for the last 12 months. The spread between 30-year Treasury yields and 5-year Treasury yields was 253 basis points on November of 2013 and now stands at 129 basis points. We have not witnessed the yield curve this flat since January 2009 and we believe this flattening trend will likely continue in 2015.

CRN: 2014-1209-4553 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.