How I Stopped Worrying and Learned to Love the Bond...and More of My Favorite Themes for 2014

Highlights

  • How I Stopped Worrying and Learned to Love the Bond... and More of My Favorite Themes for 2014. Strange to love bonds in 2014? Yes, but our love is conditional. The rise in interest rates we forecast for the coming year in shorter maturities (2-5 years) outpaces our +50 basis point forecast for longer (10+ year) maturities. Owning those longer-maturity bonds while selling shorter maturities could lead to positive returns in fixed income even as overall rates rise. A flexible strategy is key to positive fixed income returns in a rising-rate environment.
  • Shorten Your Duration, but Don't Own Short Duration. The flip side of our Dr. Strangelove strategy avoids sectors most vulnerable to rising 2-5 year maturity rates: short duration and bank loans. If the economy continues to surprise to the upside in 2014 as it appears to have at the end of 2013, then "low for longer" likely will be limited to ultra-short strategies (< 2yrs) leaving the 2-5 year segment most exposed to the failures of forward guidance we expect. For 2014, it's time to exit these very popular (and crowded) strategies.
  • Promises, Promises...Why Do I Believe? The beginning of tapering begins the shift in the Fed's policy focus from purchases to promises. The promise of persistent zero interest rates works when poor economic conditions support it; it's much more challenging when they don't. Unless growth disappoints badly, we see greater risks for curve flattening in 2014.
  • Balancing Credit and Interest Rate Risk. Quick: which do you fear more—rising rates or falling stock prices? Take the opposite of your answer and that's how we tilt our positioning recommendations for 2014. Today, the market is pricing in fear of rising interest rates, but is ignoring the increases in credit risk. While ample global liquidity still postpones the next credit cycle (and keeps us strategically overweight high yield), rising credit risk in investment grade relative to its reward and the increased valuation attraction in agency MBS moves our recommendations towards a neutral in MBS and underweight corporates.
  • What's in Your Model? Think bonds hedge your equities? They will in 2014, but not the way you like: going down when stocks go up. We look for another year of stocks beating bonds. Continue to diversify away from traditional bond strategies, but be aware of rising portfolio equity risk in doing so.
  • Inflation, Commodities and EM: Why Nations Fail. Inflation hedges continue to underperform in 2014 as falling inflation remains the greater risk. While we expect moderate increases in inflation, hedges in the form of TIPS, commodities and gold likely underperform. Longer-maturity TIPS stand out as the exception. In EM, taper repricing creates attractive opportunities for flexible strategies that can separate rate and FX risks and go both long and short.

My Favorite Themes for 2014 (and their investment implications)

2014 Themes
2014 RecommendationsRationale

How I Stopped Worrying and Learned to Love the Bond

Promises, Promises...Why Do I Believe?

Treasury/Agency:
Neutral

New this year, we overweight longer-dated rates and underweight shorter-maturity rates (leaving the sector at neutral). That reflects the large degree of Fed policy “normalization” already in 30-year Treasuries, but little priced in to 2-5 year maturities. The implication is to shed short-duration strategies.
Inflation Protected:
Neutral
Although we only expect a modest increase in inflation in 2014 relative to the historically low rates experienced in 2013, longer-maturity TIPS show significant value and we favor duration hedged TIPS exposure in longer (>10 year) maturities.
Municipals:
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We'll defer to our colleagues who manage municipal bonds for specific areas of opportunity, but will note that with muni/Treasury yield ratios much greater than 100%, and levels in excess of corporate bonds of similar rating irrespective of taxes, many muni bonds look attractive even for tax-advantaged portfolios, particularly in longer-dated munis. Puerto Rico likely faces the loss of its IG rating, which will prompt some buying opportunities.
Shorten Your Duration, but Don’t Own Short Duration Bank Loans:
Underweight
If the economy continues to surprise to the upside in 2014, then “low for longer” likely will be limited to ultra-short strategies (< 2yrs) leaving the 2-5 year segment (incl. bank loans) most exposed to the failures of forward guidance. This year we will begin to scale back from this most popular of strategies.
Balancing Credit and Interest Rate Risk High Yield:
Overweight
We keep high yield as an overweight to start 2014 as ample global liquidity continues to defer the credit cycle. However, investors with longer investment horizons might consider starting a program of paring back exposures sooner.
Agency Mortgages:
Neutral
Along the lines of rebalancing interest rate and credit risk, agency mortgages move to a neutral from what was generally an underweight in 2013. With tapering underway, valuations already reflect those risks, and spreads, particularly relative to higher quality investment grade corporates, look attractive.
Corporates:
Underweight
Tight spreads, rising credit risk and expensive valuations relative to other investment opportunities shift our allocation here to underweight.
Securitized Assets:
Overweight
The Fed’s monetary policy continues to favor housing and real estate, helping to make securitized products look attractive. This sector mainly offers income potential with relatively low interest-rate sensitivity, but investors should note that prices have fully recovered, and price risk is clearly skewed to the downside.
What’s in Your Model? Stocks Beat Bonds Stocks beat bonds again in 2014 as global policy accommodation (though slowing in the U.S.) still supports asset inflation where stocks have greater room to appreciate and bonds look vulnerable. Equity-orientated risks in fixed income (credit, converts, capital securities) likely outperform duration risks. However, overconcentration of equity risk in the portfolio when shifting fixed income exposures to these areas should be a consideration.
Why Nations Fail Non-USD:
Underweight
Tapering signals the shift in U.S. monetary policy and confidence in the economy both of which bolster the outlook for the dollar and undermine the non-USD fixed income outlook for dollar-based investors. However, FX-hedged investments such as peripheral European bonds represent a significant opportunity in 2014.
Emerging Markets:
Neutral/Overweight
Emerging markets has a constructive albeit diverging outlook. On-going rebalancing of current accounts since May mean significant parts look attractive (reforms, strong growth or rebalancing such as Mexico, Brazil, South Africa and Hungary) vs. other parts (e.g. loose policies and high refinancing needs countries such as Turkey) that may be more challenged as the Fed pulls back from QE. Overweight dollar sovereign debt; neutral on local debt (where we expect more divergence given potential currency volatility).

Fixed Income Market Strategy

Jeffrey Rosenberg and our team of market experts guide you through the complex and ever-changing world of fixed income.

The sector performance and yields listed are represented by, respectively: Barclays US High Yield Index, S&P Leveraged Loan Index, Barclays US Securitized Ex-MBS Index, Barclays US Mortgage Backed Securities Index, Barclays US Corporate Investment Grade Index, Barclays Global Aggregate ex-USD Index, JP Morgan EMBI Global Diversified Index, Barclays US Inflation Protected Securities Index and Barclays US Treasury Index. The reference indices are represented by the Barclays US Aggregate and the Barclays Municipal Bond Index.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets, in concentrations of single countries or smaller capital markets.

The opinions expressed are those of BlackRock® as of January 7, 2014, and may change as subsequent conditions vary. Information and opinions are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable. The information contained in this report is not necessarily all-inclusive and is not guaranteed as to accuracy. Past performance does not guarantee future results. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investment involves risk. Reliance upon information in this report is at the sole discretion of the reader.

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