Amid Violatility, Opportunities Surface With Fixed Income

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.)