The bond market is bracing for change in 2018. With a backdrop of a handful of expected interest-rate hikes from the Federal Reserve Board of Governors, this year could represent the start of the first bear market in bonds since the 1980s.
If nothing else, 2018 looks like a time to be nimble with bonds.
In the interviews below, fixed-income expert Rick Rieder of BlackRock puts the personnel changes at the Fed in perspective, and even manages to exude some optimism about certain mortgage securities.
Donald Ellenberger of Federated Investors acknowledges that valuations are high, but doesn't believe they can't stay high.
Other professionals point out risk factors that could throw the bond market a curveball. Think any major geopolitical event, said Anne Walsh of Guggenheim Investments.
Pimco's David Hammer weighs in on municipal bonds' prospects versus corporates this year.
The bulk of financial advisers plan to keep clients' bond portfolio allocations about the same as last year, according to an InvestmentNews survey of 310 financial advisers last month. However, about 20% plan to boost international bond exposure. In fact, one expert sees emerging market bonds as a great play this year.
Here's what the experts have to say.
Jeff Benjamin: What is your outlook for interest rates in 2018?
Rick Rieder: We're going to be in a low-rate environment for a long time. Leverage in the world is still too high, so central banks have to be extremely slow about letting rates move higher. The Fed moved in December and will likely move three times next year to get to between 2% and 2.25% by the end of 2018. That brings the system closer to equilibrium.
JB: What would derail your interest-rate outlook?
RR: If inflation does not accelerate alongside of economic growth, that would cause the Fed to be slower.
JB: What are your thoughts on the turnover at the Federal Reserve Board of Governors?
RR: James Powell will be there for sure. And Mohamed El-Erian is one of the people now being considered to join the board. They are both friends of mine. Having someone with business experience is extremely important.
Traditional economic theories don't work nearly as well when technology and business are changing so quickly. But the changes in personnel won't change the Fed's rate policy. Mr. Powell is extremely committee-oriented, as is Janet Yellen.
JB: Where are you seeing fixed-income opportunities in 2018?
RR: Emerging markets are very attractive from a rates perspective. They are growing and inflation is coming down.
The other place is buying low-duration securitized assets that are not as interest-rate sensitive, such as non-agency mortgages, commercial mortgages and collateralized loan obligations.
JB: Where do you see bond market risk in 2018?
RR: The risk is being in assets that have no upside but lots of downside when things turn. I'm talking about European rate assets, subprime auto finance and parts of the high-yield market.
Jeff Benjamin: Where do you see interest rates heading in 2018?
Anne Walsh: The short answer is, higher. But not all things move in straight lines. We do see the Fed continuing to raise rates, but we think the Fed is going to raise more than some of our peers do. We believe the Fed will raise rates four times in 2018. We think unemployment will continue to go down, and we'll see some inflation next year. We're not in the camp that says rates will continue climbing across the rate spectrum. You will not see much change on the longer end of the curve.
JB: What are the biggest risks bond investors face going into 2018?
AW: Interest rates are on a fairly predictable trajectory, and there will be continued demand from non-U.S. investors. But any type of geopolitical event is not priced in. The biggest risk to bond investors is a geopolitical or other event not in the market. Absent something like that, the fundamentals are pretty good still.
JB: When do you think the bull market in bonds will end?
AW: Based on our models, we project we'll enter recession in about two years, but don't think that will call the end of the bull market in bonds. We are still in a trend to continue to see low rates. It's coming, but calling it with precision is very challenging.
Jeff Benjamin: What challenges will the muni-bond market face next year?
David Hammer: 2018 will be all about tax reform. Muni investors had been fearful tax policy changes would reduce the value of the tax exemption. However, the new law protects the exemption while eliminating advanced refunding issues. This will likely result in a significant reduction in 2018 supply — a good thing for muni valuations, but potentially problematic for some issuers seeking to reduce financing costs.
JB: Where do you see the most opportunities for investors?
DH: There are signs of value in lower-rated municipal credit spreads. The spread between AA-rated and BB-rated high-yield muni bonds is wider than the spread on high-yield corporate bonds. The after-tax spread for munis is more than 200 basis points over corporate bonds. The last time this happened was 2013, during the "taper tantrum."
JB: How does a rising-rate environment impact muni-bond investors?
DH: We do expect the Fed to continue to raise rates. In past rising-rate cycles, munis have outperformed other fixed-income credit products, such as investment-grade corporates. We expect munis to outperform in this Fed-hiking cycle as well.
JB: Is there a way to invest in the Trump administration's proposed infrastructure spending?
DH: Historically, the best way to invest in American infrastructure is to buy muni bonds. The muni-market finances 75% of U.S. infrastructure.
We haven't yet seen a specific proposal on infrastructure projects.
The tax-reform law does allow private activity bonds issuance, which is the traditional financing vehicle for public-private partnerships. This is a step in the right direction.
That said, we believe direct investment from the federal government is necessary to really move the needle. The municipal bond markets are capable of providing low-cost financing to large scale infrastructure partnerships between the federal government and states.
Jeff Benjamin: Your bio says you're head of the Yield Curve Committee at Federated. That sounds like a lot of nerdy fun. What does that committee do? Donald Ellenberger: Funny you should say that. There was a feature on me in Barron's a few years back that described one of my bond funds as "boringly beautiful," so I guess I'm guilty as charged. At Federated, we have four top-down "Alpha Pods" responsible for positioning all of our roughly $60 billion in fixed-income assets in terms of interest-rate risk, yield-curve exposure, sector allocation and currency positioning. The Yield Curve Pod, or committee, recommends how to position our portfolios to benefit from anticipated flattening or steepening of different segments of the yield curve.
JB: What are the biggest risks facing bond investors going into 2018?
DE: There are two things that keep me up at night. One is an unexpected surge in inflation that would drive interest rates higher. No one is expecting that, and while it's certainly a black swan risk, it's not impossible either.
The second thing is being overweight in the credit sectors, including high yield, emerging markets and investment-grade corporates. Dealers don't have the incentive or ability to warehouse bonds as they did in the old days, and it could get ugly if everyone decides to sell at the same time.
JB: What is the most attractive area of the U.S. bond market now?
DE: Everything is rich, but that doesn't mean things can't stay rich for a while longer. We see no catalyst for a recession on the horizon, and that's the main thing that causes credit spreads to blow out. So, for now, we recommend overweighting high-yield, investment grade and, to a lesser extent, emerging-market bonds. Spreads may not tighten much in 2018, but even with stable spreads you'll outperform government bonds thanks to higher coupon payments. If you're worried about higher rates, bank loans are a good choice, since they offer an attractive yield with no interest-rate risk. If spreads do gradually tighten as we anticipate, look to periodically reduce your credit overweights and rebalance into Treasuries. You don't want to be the last one standing in a crowded game of musical chairs when the music stops playing.
JB: What's your outlook for Federal Reserve Board activity in the year ahead?
DE: The Fed's median dot plot anticipates three hikes in 2018, but the market is pricing in only one-and-a-half hikes. Even though the market has been more right than the Fed in predicting what the Fed will do, we're inclined to go with the Fed this time.
Global growth is in a synchronized upswing, central banks around the world, excluding Japan, are backing away from super-easy monetary policy, tax reform is happening, rebuilding from the hurricanes should boost GDP, and a weaker dollar and falling unemployment rate could start to nudge wages and inflation higher.
JB: Do you think the three-decade bull market for bonds is over?
DE: It's difficult to say. I don't think we'll see the sub-1.40% levels we saw on 10-year Treasury rates in 2012 and 2016 anytime soon. But remember that 10-year sovereign rates in Germany are just 0.34% and are 0.03% in Japan. So, the next severe recession could see us test the bottom of the long term, downward sloping channel in U.S. rates.
JB: When will it end, and what will that mean to bond-fund investors?
DE: Higher rates usually mean lower bond prices, but not necessarily negative total returns. As long as rates rise gradually and not too much, bond investors can still make money if coupon income exceeds price declines. And high-quality bonds still provide a good counterbalance in your portfolio in the event of a significant stock market reversal.
Jeff Benjamin: What is your outlook for interest rates in 2018?
Warren Pierson: We expect some modest upward pressure on rates, partially because the Fed will nudge short-term rates up. We say a little bit because there are some structural headwinds that have been in place for several years, such as an aging U.S. population of baby boomers who are retiring.
The other headwind is the theme of technology displacing labor, which has strong disinflationary factors.
JB: What do you think about the changes at the top of the Federal Reserve?
WP: We think at the margin, it adds more uncertainty. The Fed has taken its aircraft carrier into uncharted waters, and they are now backing it out and switching out half the crew at the same time. The questions is, will the market accept what they're doing?
JB: What are some of the risk factors facing fixed-income investors in the year ahead?
WP: The Fed and other global central banks have created so much liquidity that the [CBOE Volatility Index] is at all-time lows. Investors have become complacent about risk, but the risk is still there.
The concern we have is that a lot of investors are outside their normal risk parameters, and it's all been OK because volatility has been low. But if the Fed pulls back liquidity, will that cause volatility to go up?
JB: How long do you think the bull market in bonds will last?
WP: We're not market timers, so we don't try to add value by making those big calls. But it's hard for us to see an environment where rates rise significantly in the coming year. We still see a period of lower rates, longer.