LPL RESEARCH

B O N D
MARKET
PERSPECTIVES
KEY TAKEAWAYS
The Fed and inflation
will be key themes to
monitor in a couponclipping environment
where TIPS and
high-yield bonds may
add incremental value
to bond portfolios.
Todays lower yields
and higher valuations
suggest a much slower
pace of bond
performance ahead.

April 5 2016

A TALE OF TWO HALVES

Anthony Valeri, CFA Fixed Income & Investment Strategist, LPL Financial
Colin Allen, CFA Senior Analyst, LPL Financial

The first quarter of 2016 is in the record books and for most, including
bond investors, it was a tale of two halves. During the first six weeks of the
year, domestic economic concerns, worries over the state of Chinas economy,
and a near 30% decline in the price of oil sparked a strong Treasury rally that
drove high-quality bond yields lowernot just in the U.S., but globally as well.
Then the last six weeks of the quarter saw a shift for lower-rated bonds, thanks
to improving economic data and market-friendly central bank actions. Through all
the ups and downs, it was a strong quarter for bond performance; however, we
dont expect this strength to repeat over the remainder of the year.
The decline in the 10-year Treasury yield over the first six weeks of 2016 was
one of the largest for such a short time period. The 10-year Treasury yield
touched 1.7%, the low end of a broad 1.4% to 3.0% yield range since 2012.

A WILD RIDE FOR CORPORATE BOND INVESTORS

Yield Spreads to Comparable Treasuries
High-Yield (Left Scale)
Investment-Grade Corporates (Right Scale)
9.5 %

2.4%

9.0

2.2

8.5

2.0

8.0

1.8

7.5

1.6

7.0

1.4

6.5

Jan
16

Feb
16

Mar
16

1.2

Source: LPL Research,Barclays Corporate Bond Index, Barclays High-Yield Index 04/04/16
Yield spread is the difference between yields on differing debt instruments, calculated by deducting the yield of
one instrument from another. The higher the yield spread, the greater the difference between the yields offered
by each instrument. The spread can be measured between debt instruments of differing maturities, credit
ratings, and risk.

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More economically sensitive sectors, such as

corporate bonds and emerging markets debt
(EMD), weakened as investors focused on highquality bonds. The rise in average corporate bond
yield spreads shows how risk premiums increased
and then subsequently fell as recession and default
fears faded [Figure 1].

expectations improved, economically sensitive

sectors were the beneficiaries.
Despite the ups and downs, the first quarter of
2016 was a strong one for bond performance
as prices increased broadly [Figure 2]. Longerterm bonds outperformed as the threat of Fed
rate hikes, even if reduced, limited gains among
shorter-term bonds.

The final six weeks of the first quarter witnessed

a significant change for lower-rated bonds.
Domestic economic data improved, the Federal
Reserve (Fed) suggested it may slow the pace
of interest rate hikes, and more bold policy from
the European Central Bank (ECB) gave bonds a
push globally. While high-quality bond prices were
ultimately unchanged over this period as growth

The flip side of a strong first quarter of 2016 is

that valuations are now higher across the board,
presenting investors with a new challenge. Since
2008, the Barclays Aggregate has returned over
3% in only four quarters, and it has not done
so since 2011. Surprisingly, following these four

THE FIRST QUARTERS BROAD-BASED BOND STRENGTH IS NOT EXPECTED TO REPEAT

Year-to-Date Total Return
Foreign Bonds (Unhedged)
Emerging Markets Debt
TIPS
Foreign Bonds (Hedged)
Investment-Grade Corporates
High-Yield Bonds
U.S. Treasuries
Barclays Aggregate
Municipal High-Yield
Preferred Securities
Mortgage-Backed Securities
Bank Loans
Municipal Bonds
0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

Source: LPL Research, BofAMerrillLynch , Barclays Capital, JP Morgan, Citigroup 03/31/16

The indexes mentioned are unmanaged and you cannot invest into directly. The returns do not reflect fees, sales charges, or expenses. The
results dont reflect any particular investment. Past performance is no guarantee of future results.
Asset class returns are represented by the returns of indexes and are not ranked on an annual total return basis. It is not possible to invest
directly in an index so these are not actual results an investor would achieve.
Asset Class Indexes: Foreign Bonds (hedged) Citigroup Non-U.S. World Government Bond Index Hedged for Currency; Treasury Barclays U.S.
Treasury Index; Mortgage-Backed Securities Barclays U.S. MBS Index; Investment-Grade Corporate Barclays U.S. Corporate Bond Index;
Municipal Barclays Municipal Bond Index; Municipal High-Yield Barclays Municipal High-Yield Index; Bank Loans Barclays U.S. High-Yield
Loan Index; High-Yield Barclays U.S. Corporate High-Yield Index; Emerging Markets Debt JP Morgan Emerging Markets Global Index; Foreign
Bonds (unhedged) Citigroup Non-U.S. World Government Bond Index (unhedged)

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quarters, the gains in high-quality bonds slowed,

but remained positive, with an average return of
1.0% in the following quarter and 1.6% over the
following six months (according to the Barclays
Aggregate). As mentioned in the Bond Market
Perspectives, How Extreme It Is, extreme
strength in the Treasury market usually fades, but
does not necessarily reverse, in the short term.

KEY THEMES
Two important factors that may determine the path
for bond yields are:
Central banks. Market-friendly central bank
policy was a key driver of bond performance,
but it appears unlikely central banks will be able
to deliver more good news. The ECB and the
Bank of Japan already maintain interest rates
below 0%, and fed fund futures already reflect
a very benign Fed with only one interest rate
hike priced in for all of 2016. While central banks
may maintain market-friendly policies, and help
support bond prices in the process, additional
bond price gains may be unlikely absent
renewed deterioration in economic data.

Todays lower-yielding environment suggests that

while prices may hold steady, investors should
prepare for lower returns compared to these
prior periods. A coupon-clipping environment,
where investors merely receive ongoing interest
payments, still has the potential to add to
performance but at a slower pace. Figure 3 shows
total return estimates based on a nine-month time
horizon for a given change in the 10-year Treasury
yield. If bond prices remain range bound with
stable prices, investors may reap an additional
2.4% over the remainder of 2016.

Inflation. Fed Chair Janet Yellen recently

dismissed the increase in inflation as temporary
(a change in tune) but doubts remain. Market
inflation expectations continue to rise, and
if Yellen and company are wrong about any
softening in inflation, bond prices may weaken
as investors demand higher yields to offset rising
inflation risks. Inflation expectations finished the
first quarter of 2016 higher [Figure 4].

However, we expect interest rates to rise slightly

as economic growth improves over the remainder
of 2016, continuing the improvement witnessed
over the past six weeks. Figure 3 also illustrates
that if the 10-year Treasury yield rises by 0.5%
over the remainder of the year, total return may be
negative for high-quality intermediate bonds. Given
the still sluggish pace of global growth and central
banks market-friendly approach, an increase of
more than 0.5% may be unlikely, in our view.

Global economic growth will be a focal point as

always and has an influence on Treasury yields.
The Treasury yield curve, as measured by the yield
differential between 2- and 10-year Treasuries,
steepened slightly over the last six weeks of

MORE MUTED RETURNS COULD BE IN STORE OVER THE REMAINDER OF 2016

Change in Bond Yields, %

-.75

-.50

-.25

.25

.50

.75

Total Return, %

6.5

5.1

3.7

2.4

1.0

-0.4

-1.7

Source: LPL Research, Barclays Index data 04/01/16

Scenario analysis is based on a return of 2.4% as of 04/01/16 for the Barclays Aggregate, based upon a nine-month time horizon, parallel shift in the yield
curve, no change to yield spreads, and no reinvestment of interest income.
This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not
reflect the deduction of fees and charges inherent to investing.
Indexes are unmanaged and cannot be invested into directly.

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the first quarter but still resides at a level that

continues to reflect a sluggish growth environment.
Bond investors await more proof from the global
economy before pushing yields materially higher.
In the meantime, central banks and inflation
remain focal themes. The Fed may be in a pickle
and forced to take a slow path in raising rates as
more rate hikes could push the U.S. dollar higher,
which, in turn, may adversely impact exports and
manufacturing. But a go-slow approach potentially
risks higher inflation. For now, remaining calm on
inflation remains the lesser risk for the economy.

TIPS
If inflation does not revert lower, and the Fed
allows modest stagflation to develop, Treasury
Inflation-Protected Securities (TIPS) may continue
to benefit. However, like other segments of the

INFLATION EXPECTATIONS CLOSED THE FIRST

QUARTER HIGHER

10-Year Breakeven Inflation Rate

1.7 %

1.5
1.4
1.3
1.2

Jan
16

Feb
16

Mar
16

Source: LPL Research, FactSet 04/04/16

The breakeven inflation rate is the difference between the nominal
yield on a fixed-rate investment and the real yield on an inflationlinked investment of similar maturity and credit quality.

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HIGH-YIELD
The average yield spread of high-yield bonds
dropped to 6.9% at the end of the first quartera
fair valuation given rising defaults. However,
although defaults are increasing, they are still
largely concentrated in energy and metals and
mining. Even at valuations we find fair, the average
yield of high-yield bonds, near 8%, stands out and
may be an important source of return in a couponclipping environment. High-yield bonds have not
shaken their sensitivity to oil prices and the pace
of defaults remains an important variable. Despite
the potential for some renewed volatility, we
believe longer-term investors may be rewarded
with a small allocation to high-yield bonds and
compensated for risks.

CONCLUSION

1.6

1.1

fixed income markets, we do not expect a repeat

of a strong first quarter. Still, in a low-return
environment, the inflation compensation of TIPS
could provide an extra boost for high-quality bond
investors as inflation expectations remain very low
in a historical context.

The strength in fixed income markets witnessed

during the first quarter of 2016 is not expected to
repeat. Although recent history shows a significant
reversal is unlikely, the remainder of the year may
be muted, with the best 2016 has to offer for
bonds potentially behind us absent a recession.
The Fed and inflation will be key themes to monitor
in a coupon-clipping environment where TIPS and
high-yield bonds may add incremental value to
suitable bond portfolios. n

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IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To
determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no
guarantee of future results. All indexes are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to
availability and change in price.
Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed
rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.
High-yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded
BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
Treasury Inflation-Protected Securities (TIPS) help eliminate inflation risk to your portfolio, as the principal is adjusted semiannually for inflation based on the
Consumer Price Index (CPI), while providing a real rate of return guaranteed by the U.S. government. TIPS are subject to market risk and significant interest rate
risk as their longer duration makes them more sensitive to price declines associated with higher interest rates. TIPS do not pay the inflation-adjusted balance until
maturity, and the accrued principal on TIPS could decline, if there is deflation.
Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate, and credit risk as well
as additional risks based on the quality of issuer coupon rate, price, yield, maturity, and redemption features.
Investing in foreign fixed income securities involves special additional risks. These risks include, but are not limited to, currency risk, political risk, and risk
associated with foreign market settlement. Investing in emerging markets may accentuate these risks.
INDEX DESCRIPTIONS
The Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable
bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and
CMBS (agency and non-agency).
Barclays U.S. High Yield Loan Index tracks the market for dollar-denominated floating-rate leveraged loans. Instead of individual securities, the U.S. High Yield
Loan Index is composed of loan tranches that may contain multiple contracts at the borrower level.
The Barclays U.S. Corporate High Yield Index measures the market of USD-denominated, noninvestment-grade, fixed-rate, taxable corporate bonds. Securities are
classified as high yield if the middle rating of Moodys, Fitch, and S&P is Ba1/BB+/BB+ or below, excluding emerging market debt.
The Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate, taxable corporate bond market.
The Barclays U.S. Mortgage Backed Securities (MBS) Index tracks agency mortgage backed pass-through securities (both fixed rate and hybrid ARM) guaranteed
by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC)
The Barclays U.S. Municipal Index covers the USD-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general
obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.
The Barclays Municipal High Yield Bond Index is comprised of bonds with maturities greater than one-year, having a par value of at least $3 million issued as part
of a transaction size greater than $20 million, and rated no higher than BB+ or equivalent by any of the three principal rating agencies.
The Barclays U.S. Treasury Index is an unmanaged index of public debt obligations of the U.S. Treasury with a remaining maturity of one year or more. The index
does not include T-bills (due to the maturity constraint), zero coupon bonds (strips), or Treasury Inflation-Protected Securities (TIPS).
The Citi World Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. The WGBI is a widely used
benchmark that currently comprises sovereign debt from over 20 countries, denominated in a variety of currencies, and has more than 25 years of history available. The
WGBI provides a broad benchmark for the global sovereign fixed income market. Subindexes are available in any combination of currency, maturity, or rating.
The JP Morgan Emerging Markets Bond Index is a benchmark index for measuring the total return performance of international government bonds issued by emerging
markets countries that are considered sovereign (issued in something other than local currency) and that meet specific liquidity and structural requirements.
This research material has been prepared by LPL Financial LLC.
To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial LLC is not an affiliate of and
makes no representation with respect to such entity.
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RES 5429 0416 | Tracking #1-458479 (Exp. 04/17)

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