Bond outlook: Where to find yield in the 4Q

Solid results from the fixed income markets in 3Q mask the fact that it was yet another roller coaster quarter within another volatile year
NOV 10, 2010
By  mlanche
The following is an excerpt from the fourth quarter outlook authored by Prudential Fixed Income, a unit of Prudential Investment Management Inc. To read the full commentary, click here. Solid results from the fixed income markets in 3Q mask the fact that it was yet another roller coaster quarter within another volatile year. Sources of volatility ranged from the US economy and Fed policy to concerns about a hard landing in China to the ongoing crisis in the European peripheral countries. Although the decline in US Treasury yields has powered fixed income returns so far this year, the excess returns of the corporate and other non-government sectors have come primarily from their excess yield rather than from spread compression.

CYCLES WITHIN CYCLES

Generally, the market's ups and downs in 3Q followed economic gyrations fairly closely. Benefiting from the European/IMF rescue packages and less onerous than expected financial legislation, risk appetite held up well early in 3Q, allowing spreads to contract as interest rates held relatively steady. Soon after, disappointing US and Chinese economic data and a rapid drop-off in US home sales, combined with ongoing concern over European sovereign risk, pushed rates lower and spreads wider. In September, spreads tightened again across most fixed income sectors on signs of more stable economic data, dovish signals from the Fed, and a rallying stock market.

THE 800-POUND GORILLA

After generally declining for 30 years, US interest rates are now just plain low and we believe are likely to stay that way for quite some time. Here's why: 1) Economic Recovery to Remain Sluggish Numerous studies show that recessions coinciding with global financial crises tend to be followed by several years of sluggish growth, and this post-financial crisis economic recovery appears no different. Needless to say, this kind of slack economic climate is conducive to low interest rates. 2) Credit Contraction is Crimping Net Supply of Debt Although gross issuance of US Treasury and corporate bonds is now at record levels, the US is experiencing a net private sector credit contraction not seen for more than 50 years, leaving overall net credit supply at manageable levels. Tepid confidence, high unemployment, and high indebtedness are driving household debt lower, while the financial sector continues to downsize its balance sheets on a massive scale. 3) Demand, Demand, and More Demand The demand backdrop is strong and likely to remain so. Disappointed by the stock and real estate markets, retail investors have been consistently buying bonds since early 2009, attracted to their income and relative principal stability. Banks are another positive. With troubled assets high and favorable lending prospects low, the liquid high quality fixed income markets have attracted significant interest from banks. In addition, many developing countries have generated substantial trade surpluses, despite the sluggish global recovery. Lacking deep domestic markets, these hard currency surpluses are being funneled back into high quality bonds of developed countries, particularly the US. Finally, some US corporate pension plans are in various stages of adopting liability-driven investment strategies, which increase allocations to fixed income. 4) Fed Policy Another Market Positive In late 3Q, the Fed signaled the possibility of further monetary policy easing, most likely through the additional purchase of US Treasuries. Whether or not the Fed carries through on the program, its bias nonetheless suggests the Fed funds rate is likely to remain near zero well into 2011, or beyond. The potential Fed buying program, combined with a near-zero Fed funds rate for an extended period, should serve as an anchor that will keep US Treasury rates low at least through year end.

VOLATILITY TO REMAIN ELEVATED

In addition to the ongoing risks that buffeted the markets last summer, we can add a few more in 4Q. Thanks to the upcoming November election, we can also look forward to headline risk as politicians grandstand about taxes, government spending, and trade policies. Risks aside, we view today's secular, cyclical, and Fed policy backdrop as bond market friendly and look for investors to push further out on the curve, down in quality, and across the fixed income spectrum in search of yield. For more research and commentaries, visit news.prudential.com. Like what you've read? Subscribe to Market INtelligence »

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