Amid Violatility, Opportunities Surface With Fixed Income

Brian Selzer

OCEAN CITY — The actions of the Federal Reserve (Fed), a softer set of

economic data from the U.S. and turmoil in the Emerging Markets have weighed on risk assets so far in 2014. What has gone slightly under the radar is the stronger start for fixed income.

After declining 2% last year, bonds gained 1.5% in January, with high quality and long duration leading the way. However, we do not believe the performance in January sets the trend for the year. Bank of America Merrill Lynch (BofAML) Global Research’s base case is still for the U.S. economy to grow by 3% in 2014, leading to a more challenging environment for fixed income returns.

January’s fixed income performance does serve to highlight two key considerations for portfolios: 1. high-quality fixed income (Treasuries and Municipals) can still provide diversification when equities retreat; and 2. where investors seek income from bonds, we continue to prefer opportunities in high yield.

When seeking portfolio diversification through fixed income, looking to municipals is a good starting point, in our view. In January, high-quality municipal bonds (as measured by the Bank of America Merrill Lynch AAA U.S. Muni Securities Index) were up 2.3%. This was in a month when the S&P 500 Index fell nearly 4%.

We are constructive on municipal bonds for several reasons.

First, on an after-tax basis, municipal yields continue to look very favorable relative to those of Treasuries and similarly rated investment grade corporates. Second, states and local governments have started to address the major issue of pension underfunding and improving state and local tax revenues continue to support fiscal balances. Third, the shrinking supply of municipal issuance should help support future prices.

We believe the key is to differentiate among governmental issuers and avoid concentration in a single geography, particularly one with a high debt burden and weaker economic prospects, such as Detroit or Puerto Rico.

In our view, an active manager with strong credit research in this sector can better steer clear of the troubled borrowers and construct a diversified

national municipal portfolio.

High-yield bonds have less sensitivity to interest rate risk than Treasuries and high-grade corporate bonds. In addition, better economic growth, along with accommodative monetary policies and improving bank lending conditions, should continue to limit default rates and otherwise support the category.

Currently, high-yield bonds can be a source of additional income. Opportunities for capital appreciation are more limited now, following a considerable compression in yields in the last three years. Investors should also be aware that a lot of the good news may already be incorporated in high yield prices.

While we still expect high yield to lead U.S. fixed income this year, returns are unlikely to match the 7.4% achieved in 2013.

Our base case calls for a gradual rise in long-term rates in 2014. BofAML Global Research forecasts 10-year Treasury yields to rise to 3.75% by the end of 2014. We urge investors to consider fixed income within the broader context of diversification, and to manage risk around interest rate volatility rather than abandon the asset class altogether.

Towards that end, we suggest considering bond laddering strategies,

taking credit risk over duration risk and favoring allocations to municipals and high-yield credit.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)

Equities: A Recent Pullback, Not A Change In Trend

OCEAN CITY — In our December Monthly Letter (Improving Growth, Low Inflation and Favorable Markets), we expected higher market volatility in 2014 driven by the reduction in monthly bond purchases by the Federal Reserve (Fed). What we had not expected was 38 days into the year, equity markets would have been hit by a range of Emerging Markets events, including … Continue reading

New Expectations For A New Year

OCEAN CITY — With interest rates at historic lows, resulting in lower income from bonds, achieving investment goals has brought about a shift in portfolios that has tilted them toward equities. This raises the importance of understanding the drivers of equity returns over the near term. Three components drive total returns of equities: dividends, earnings growth and valuation changes (for … Continue reading

2014 Financial Resolutions To Consider

OCEAN CITY — For the average equity investor, 2013 was certainly a year to celebrate. As financial markets and the global economy continue to normalize, we outline some key investor resolutions for 2014. Resolution #1: Pay attention to the economy and the Federal Reserve. The macroeconomic backdrop has been a critical determinant of asset performance in recent years. We think … Continue reading

Strategies To Utilize When Selling The Family Home

OCEAN CITY — Among life’s transitions, dealing with a family estate — and the sale of the family home — may be the most trying. Few transactions have the potential to be as emotionally charged. Yet those emotions can interfere with the many important decisions that family members must make together. “Even if you all agree that it’s necessary to … Continue reading

Retirement Concept Quite Different Now Than Before

OCEAN CITY — Today, working in retirement isn’t a purely financial decision. Americans are living longer, and in a world where the average 65-year-old can expect to live well into his or her 80s, what were once known as the post-work years have become the springboard for new, fulfilling journeys — each different from the other. “Our whole concept of … Continue reading