Economic News & Analysis - March 19, 2012
Bond market update
By James Kochan, Chief Fixed-Income Strategist

Jim Kochan photo

Summary:

  • The bond markets are adjusting to somewhat healthier economic indicators that have removed the near-term prospect of more quantitative easing by the Federal Reserve (Fed).
  • Looking at our strategic recommendations for 2012, we remain focused on those markets that we believe could continue to produce positive returns even if Treasury yields were to increase, namely the high-yield corporate market and the A/BBB segments of the municipal market.
  • Since we do not believe this is the beginning of a prolonged uptrend in market yields, we recommend that investors consider reducing cash positions in favor of income-oriented investments between now and mid-April.
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The bond markets are adjusting to somewhat healthier economic indicators that have removed the near-term prospect of more quantitative easing by the Fed. In addition, a better outlook for the euro markets has probably reduced foreign demand for Treasuries, now that Greece has received another cash infusion. Taken together, these factors have produced a correction in the Treasury market that has pushed up the yield on the 10-year Treasury note by approximately 50 basis points (100 basis points equals 1.00%) since February 1.  

While more quantitative easing might not be in the offing, investors should keep in mind that a shift to a tighter Fed policy is at least a year off. Some Fed officials believe it is still two years off. Thus, the recent rise in market yields is probably not the onset of a prolonged cyclical bear market in bonds. Cyclical uptrends in bond yields have historically been sustained by Fed tightening. In the absence of Fed tightening, bond market corrections are typically limited in duration and scope.

Because the Treasury market benefited the most from both the Fed’s largesse and strong demand from foreign investors, it has sold off the most over the past three weeks. Corporate and municipal market yield increases have been half of those in the Treasury market. In the municipal market, yields on 10-year maturities have increased approximately 25 basis points since early February. These increases were due in part to seasonal factors, as new-issue calendars typically begin to build in March and April, and the mid-April tax date often brings some redemptions from tax-exempt investments. The portfolio managers at Wells Fargo Advantage Funds® were anticipating these events when they materially reduced portfolio durations earlier this year.

A crush of new issues also contributed to a 25-basis-point rise in yields in the 10-year segment of the high-yield corporate bond market. Earlier this month, yields in that market were approaching the record lows of 2005, and those favorable borrowing terms attracted a flood of new bond offerings. In addition, supply pressures might have pushed yields higher, even in the absence of a correction in Treasuries.

The year thus far

Looking at our strategic recommendations for 2012, we remain focused on those markets that we believe could continue to produce positive returns even if Treasury yields were to increase, namely the high-yield corporate market and the A/BBB segments of the municipal market. Thus far in 2012, those markets have performed quite well, while Treasuries have not. The Merrill Lynch High Yield Master Index has a total return of 5.1% thus far in 2012, and the Merrill Lynch Municipal Master Index return is 2.1%. In contrast, the Bank of America Merrill Lynch U.S. Treasury Index return is -1.8%.

We still believe that over the next 12 months, total returns in those sectors will approximate the coupon income, which is in the 6.0% to 7.0% range for high-yield corporate bonds, 3.5% to 4.5% for short-term high-yield bonds, and 3.0% to 4.0% for municipal bonds. Further, we still suggest avoiding Treasuries and Treasury Inflation-Protected Securities (TIPS) until those yields adjust somewhat higher.

Investors in cash and cash-equivalent portfolios should be reminded that those portfolios are likely to produce returns close to zero again in 2012 and perhaps in 2013. Clients with a higher risk tolerance should consider taking advantage of this market correction by investing for income. Safety is more expensive now than it was in January. The market correction in Treasuries might not be completed, so corporate and municipal yields could rise somewhat in the weeks ahead. However, since we do not believe this is the beginning of a prolonged uptrend in market yields, we recommend that investors consider reducing cash positions in favor of income-oriented investments between now and mid-April.

Past performance is no guarantee of future results. Securities issued by the U.S. government are guaranteed as to the timely payment of principal and interest.

High-yield securities have a greater risk of default and tend to be more volatile than higher-rated debt securities.

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