By Gregory S. Kaplan, CFA

Key Takeaways:

  • Short rates set to rise, with long rates range-bound
  • Rates will dominate fixed income returns
  • Expect positive but below trend returns

Our forecast entering 2018 suggested that fixed income returns would be affected primarily by higher rates, firming inflation, and the Federal Reserve. This view has proven correct, with the Bloomberg Barclays Aggregate Bond Index declining 1.46% in the opening months of 2018. Market rates rose in the first part of the quarter due to the tax cuts, rising optimism by businesses and consumers, and a commensurate increase in inflation expectations. As the quarter wound down, this optimism faded as consumption remained weak, policy uncertainty increased, and stock market volatility returned. As of this writing, the 10-year Treasury is up 35 basis points but remains 20 basis points below its 2.95% peak on Feb. 21.

QU 1Q18 Kaplan Chart 1

The Fed, led by new chairman Jerome Powell, has played a large and visible role in market sentiment as the Federal Open Market Committee progresses further down its well-broadcast path of gradual rate hikes. In response to stronger fundamental factors and more hawkish voters joining the FOMC, City National Rochdale increased its expectations from three to four hikes this year (one more than Fed projections).

This expectation is largely priced into shorter maturity bonds, but inflation remains the key driver for longer-term yields. Deficit spending, coupled with an accelerating economic growth trajectory, led the market to price in higher inflation in the future, hurting long-term bonds for most of the quarter. This has largely reversed, however, as actual inflation remains subdued and the trade war heats up.

QU 1Q18 Kaplan Chart 2

Looking forward, we expect continued volatility in rates as uncertainty about recent fiscal stimulus, future policy actions, Fed rate hikes, and the budget deficit weigh on sentiment. We are targeting neutral to short duration and utilizing a barbell structure to capture the anticipated further flattening of the yield curve. In anticipation of a potential turn in the credit cycle in 2019-2020, we are taking advantage of tight credit spreads and strong markets to upgrade the quality of our portfolios. Overall, we continue to expect returns for investment grade fixed income in the lower single digits this year with greater potential upside in the opportunistic income sectors.

Read the next article in the series: Rising Rates Don't Have to Hurt High Dividend Stocks.

Index Definitions

Bloomberg Barclays U.S. Municipal High Yield Index: measures the non-investment grade and non-rated USD-denominated, fixed-rate, tax-exempt bond market within the 50 United States and four other qualifying regions (Washington DC, Puerto Rico, Guam, and the Virgin Islands). The Index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.

The Bloomberg Barclays Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year.

Bloomberg Barclays U.S. Corporate High Yield Index: measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below.

The Bloomberg Barclays Emerging Markets Hard Currency Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD-denominated debt from sovereign, quasi-sovereign, and corporate EM issuers.

The S&P/LSTA U.S. Leveraged Loan 100 Index is designed to reflect the performance of the largest facilities in the leveraged loan market.

Bloomberg Barclays Intermediate U.S. Corporate Index: measures the performance of U.S. corporate bonds that have a maturity of greater than or equal to 1 year and less than 10 years. The Index is a component of the Barclays U.S. Corporate Index and includes investment grade, fixed-rate, taxable, USD-denominated debt with $250 million or more par outstanding, issued by U.S. and non-U.S. industrial, utility, and financial institutions.

The Bloomberg Barclays US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index.

Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.

Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer duration fixed-income securities and during periods when prevailing interest rates are low or negative.

Investments in below-investment-grade debt securities, which are usually called “high-yield" or “junk bonds," are typically in weaker financial health, and such securities can be harder to value and sell, and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors' incomes may be subject to the Federal Alternative Minimum Tax (AMT) ,and taxable gains are also possible.

Investments in the municipal securities of a particular state or territory may be subject to the risk that changes in the economic conditions of that state or territory will negatively impact performance. These events may include severe financial difficulties and continued budget deficits, economic or political policy changes, tax base erosion, state constitutional limits on tax increases, and changes in the credit ratings.

All investing is subject to risk, including the possible loss of the money you invest.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.

Diversification does not ensure a profit or protect against a loss in a declining market.

Past performance is no guarantee of future performance.

Investment management services provided by City National Bank through its wholly owned subsidiary City National Rochdale, LLC, a registered investment advisor.