As we enter 2014 and the Federal Reserve begins to taper its bond-buying program, what does Principal Global Fixed Income expect from markets in 2014, and what are our recommendations? This blog post represents a compilation of our key themes and outlooks, and our recommendations for 2014. Overall, our thoughts for 2014 are Expand Credit, Shorten Duration, and Look to Europe.
- Theme #1 – Credit spreads expected to tighten in 2014.
- There’s plenty of runway for fixed income in 2014, thanks to quantitative easing (QE) and a low default rate. One byproduct of the last several years of QE has been increased refinancings. This is a positive fundamental for fixed income and helps to keep defaults well below their long-run averages while keeping interest-coverage levels relatively high.
- Theme #2 – Security selection will matter as idiosyncratic risk increases.
- Leveraged buyouts, mergers and acquisitions, and initial public offerings are all expected to increase.
- Industries most susceptible include: tech/media/telecom; pharmaceuticals; food & beverage; independent exploration & production; and pipeline general partners.
- Theme #3 – The path is never straight.
- Expect increased interest-rate volatility through 2014, leading to general market volatility and dealer selling.
- Dealer balance sheet exposure to corporate bonds is near the upper end of the recent range (US$5 to US$15 billion), but not of sufficient size to dampen volatility in weaker markets.
- Recommendation – Expand Credit Allocation – Yield seekers should look to high yield.
- The effect of QE on equities has been a rush into income-producing equity classes. This is why we saw equity markets underperform in both second and third quarters; when rates moved higher, money flowed out. If you’re looking for yield, consider CCC-rated high yield bonds in 2014.
- Recommendation – Shorten Duration, But Don’t Eliminate It – Yield curves are steep
- What makes the current period different is that the yield curve is steep rather than flat – meaning yields are quite a bit higher the further out you look. When the yield curve is relatively flat, it’s easier to shorten duration because you don’t have to give up much yield. That’s not the case today. There is a cost to eliminating all duration. As of this writing, the yield on the five-year Treasury has gone up 81 basis points (bps), but two-year has only increased by 8 bps.
- The belly of the yield curve is that area between five years and 20 years and will likely get hit hardest as rates begin to climb. We expect the front end (1-5 years) and long-end (20-30 years) to continue to outperform.
- Continued demand for long and short credit will buoy the front and back end of the curve
- Recommendation – Look to Europe – Land of Opportunity…for credit
- European high yield market has set consecutive years of record new issuance; and over 40% of issuance in 2013 for the European high yield market was first-time issuers.
- Yankee bonds (e.g. European bonds issued in U.S. dollars) will continue to benefit from improving global growth and continued monetary policy accommodation.
So for 2014, we recommend your fixed income plan include shortening duration, increasing your exposure to credit, and looking to Europe for new opportunities. If you “avoid the belly” of the yield curve, you can likely reduce duration without sacrificing significant yield and capture the alpha from your increased credit exposure.
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