We have increased our full-year 2016 total return forecast for high-quality bonds to a low- to mid-single-digit total return, up from flat, as discussed in our just released Midyear Outlook 2016: A Vote of Confidence publication. A reduced number of Federal Reserve (Fed) rate hikes, continued aggressive policy easing by overseas central banks (most notably the European Central Bank and Bank of Japan), and below-trend economic growth translate to a more supportive backdrop for bonds globally. We expect limited bond returns over the second half of 2016. Expensive valuations and low yields may remain in place.
The “good” news (for bonds) has been largely factored into current prices and absent signs of economic deterioration, further price gains, if any, may be limited. We expect the 10-year Treasury yield to finish the year roughly unchanged to 0.25% higher compared to a June 30, 2016 reading of 1.5%. An increase of 0.5% is certainly possible if the economy improves more than we expect over the second half of 2016, but tighter financial conditions due to Brexit may still mute the Fed’s response. The 10-year Treasury yield is still likely on track to finish lower for all of 2016.
Given lingering questions about the global economy (especially post-Brexit) and the still large yield advantage of U.S. Treasuries compared to other high-quality government bonds overseas, high-quality bond demand may stay elevated and limit potential weakness, if any. Our scenario analysis illustrates potential return outcomes over the final six months of 2016 (see the figure below) and also shows that if stocks or the economy falter and yields decline further, high-quality bonds still play an important diversification role even at near-record low levels.
Rising to the Challenge Amid Limited Opportunities
In a world of limited opportunity, an emphasis on higher-quality bonds may be prudent until better value emerges. Specifically, mortgage-backed securities (MBS) may offer opportunity in a world of expensive alternatives. We find MBS valuations attractive after failing to match the pace of Treasury gains over the first half of 2016. The sector offers more yield per unit of interest rate risk (duration) than most other bond sectors.
Investment-grade corporate bonds are another way to reap added interest income but, on average, that market possesses greater interest rate sensitivity. Combining MBS with investment-grade corporate bonds can help offset potential interest rate risk while still maximizing sources of income in today’s market. Investment-grade corporate bonds also may benefit from the economic improvement we anticipate over the second half of 2016. With an average yield spread of 1.4% above comparable Treasuries, just above the 1.3% 20-year average, investment-grade corporate bond valuations are roughly fair to slightly more attractive than Treasury alternatives. Focusing on intermediate bond strategies, that in our view combine a reasonable trade-off between yield and interest rate sensitivity, may be the best approach to combine the potential benefits of each sector.