Brian Rehling, CFA ®
by
Co-Head of Global Fixed Income Strategy

Analysis and outlook for the fixed income market

  • We recently saw the most significant monthly sell-off in domestic fixed income in years. As a result, some investors are rethinking their fixed-income portfolio allocation.
  • In this report, we share our perspective on these changes based on historical trends and recent global fixed-income developments.

What it may mean for investors

  • While we expect fixed-income volatility to be elevated going forward, we do not expect that rates will only move higher from here. We advise investors to revisit why they owned fixed-income positions before the domestic sell-off. In most cases, those reasons continue to warrant owning fixed-income allocations.
  • We also advise investors to diversify their income streams globally and by asset class and sector.

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Fixed Income—Is the Damage Done?

We have seen a sharp sell-off in fixed income asset classes since the election. The rapid decline has many investors asking if the sell-off has gone too far, too fast, or if more weakness could be expected in the months ahead. As fixed-income investors review month-end performance, these questions are likely to intensify.

Performance

Many fixed-income investors should expect to see market-based losses of 2-3 percent in the month of November reflected on their statement’s fixed-income holdings. Such statement losses are not realized until an individual bond is sold, but they are reflective of current mutual fund and exchange-traded-fund market values (and the current market values of individual bonds). Those who have a concentration in shorter maturities or lower-credit-quality holdings should typically expect smaller market-based losses, while investors with a bias toward longer-maturity positions could expect more significant losses.

Table 1. Selected November Fixed-Income Index Performance


Table of selected November fixed-income index performance. Contact your Relationship Manager for more information.

Source: FactSet, 12/1/16. Past performance is no guarantee of future results. See end of report for important risk information and index definitions. Inflation-Linked Fixed Income equates to Treasury Inflation-Protected Securities.

The Bloomberg Barclays U.S. Aggregate Bond Index, which tracks the U.S. investment-grade bond universe, posted a loss of -2.4 percent last month. This is the largest monthly loss for the index since April 2004, which was just before the Federal Reserve (Fed) embarked on a significant rate-increase program that took the federal funds rate from one percent to more than five percent over the course of the following two years.

Often, when we see significant moves in the bond market, we can expect it to take two to four months to find a near-term bottom. Over the past 20 years, we have seen a number of periods in which fixed-income yields adjusted dramatically higher. Chart 1 looks at the time between trough and peak for these periods. These adjustments typically take months to unfold; however, the majority of the pricing move often happens early during the adjustment. We do expect further weakness in the days ahead as traders continue to look for a near-term bottom in fixed-income markets.

Table 2. Significant Bond-Market Rate Increase Periods


Table of significant bond-market rate increase periods. Contact your Relationship Manager for more information. 

Source: Bloomberg, Wells Fargo Investment Institute, 12/1/16

Chart 1. Change in 10-Year Treasury Yield—Taper Tantrum vs. President-elect Trump Victory


Graph of change in 10-year treasury yield. Contact your Relationship Manager for more information. 

Source: Bloomberg, Wells Fargo Investment Institute, 12/1/16 Past performance is no guarantee of future results. Taper tantrum is a reactive response to the Federal Reserve doing something that is perceived to be bad for the market.

For some historical context, we compared the 10-year Treasury yield movement associated with the 2013 taper tantrum with the move we have seen so far following the Republican presidential victory. Early yield moves following each of these events were significant, and while history and trading trends suggest that we have not yet reached a bottom in fixed-income markets, as we progress through this period, future increases in the 10-year Treasury yield are not likely to be as dramatic as the recent yield spike.

We do expect bonds to recover at some point, and we do not believe that this is the start of a longer-term trend in which rates continually move higher. Our current year-end 2017 yield targets suggest that longer-term yields will end next year near current levels—even as near-term inflation data and fiscal uncertainty may increase yield volatility. The macro trends that support a low-rate environment over the longer term include the following:

  • Inflation expectations remain near historically low levels—even as near-term inflation measures appear to be edging higher.
  • Interest rates that are well below U.S. yields in many countries should continue to provide support to domestic fixed-income markets as global investors seek higher-yielding assets.
  • An aging population suggests that strong demand for income securities is likely to continue.
  • Inflated central-bank balance sheets are continuing to limit the available supply of longer-dated bonds.
  • Significant government-debt levels are limiting the potential for sustained fiscal spending.

Volatility

We expect bond-market volatility to pick up given the new domestic fiscal uncertainties. As a result, investors may need to become more nimble with their fixed-income positioning. Since 2014, 10-year Treasury yields have generally been moving lower with relatively little volatility. This period of strong performance with few swings in prices may have lulled some fixed-income investors into complacency. Significant volatility in the fixed-income market is not uncommon, and bond-market volatility often comes in spurts.

Since 2000, the average calendar-year trading range (the difference between the year’s highest and lowest yield) for the 10-year U.S. Treasury note has been 142 basis points or 1.42 percent. So far in 2016, we have seen a trading range of just under 110 basis points (or 1.1 percent) for the 10-year Treasury note. Despite the recent rise in yields, this year has remained less volatile than an average year.

We expect that fixed-income investors will, over the course of the next year, be subject to more yield volatility than we have seen over the past three years. We would remind investors that, while volatility is likely to pick up, bonds generally remain a far more stable asset class than equities (based on longer-term, historical trends).

Revisit Why You Own Bonds

Many investors are rethinking their fixed-income allocation in the face of the recent market sell-off. We acknowledge that risks are heightened in the fixed-income asset group, and return outcomes are more unpredictable over the near term. If you are considering moving away from the recommended fixed-income allocations, we recommend that you consider the following reasons fixed-income positions are included in most asset-allocation models (before doing so).

Diversification. The future is often uncertain, more so now than in recent history. While we may have a strong feeling of what tomorrow will bring, unforeseeable events often alter reality. Taking too large a bet on any one particular outcome increases your risk significantly. Investment strategies based on concentrated allocations are usually higher-risk. During the recent period of fixed-income underperformance, we have seen the equity market hit new all-time highs. This negative correlation between asset classes is of benefit to investors. During periods of equity weakness, it is possible that fixed-income allocations will provide the best performance.

Reduced Volatility. One of the primary reasons to continue to own fixed-income investments, even if interest rates continue to increase, is the lower volatility these investments typically offer when compared to stocks over the longer term. Bonds, when used properly as part of a diversified investment strategy, may help smooth out your portfolio’s overall performance in the long term.

Liquidity. Most bonds have a maturity date at which principal is returned to the investors if the issuer has not defaulted or redeemed the issue. If you are able to anticipate future cash needs, purchasing high-quality credit instruments with maturities near those occasions can be an effective way to remain invested in the markets while maintaining some assurance that funds will be available when you need them.

Income. Income and cash flow are important needs for most investors. If you hold an individual bond to maturity and the issuer does not default (or redeem the security), you will receive your expected cash flow, regardless of whether interest rates increase or decrease. As interest rates move up, new capital can often be deployed into higher-yielding assets, providing an increase in overall portfolio income. Additionally, it is important to remember that if you have locked in a yield for a long period of time and the prices of goods and services you buy begin to rise rapidly, you may not be able to generate enough cash flow to meet your spending needs. With most bonds, your cash flow is generally fixed until the bond you hold matures.