Still Not a Front Runner: Potentially Low-Returns for Bonds

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.

07-15-16_blog_fig1

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.

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

Economic forecasts set forth 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 and bond mutual fund values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

Mortgage-backed securities are subject to credit, default, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, market and interest rate risk.

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.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Federally tax free but other state and local taxes may apply.

Investing in foreign and emerging markets debt securities involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical and regulatory risk, and risk associated with varying settlement standards.

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).

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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