Despite predictions about rising rates & fears of an imminent bear market in bonds, fixed income investors experienced a solid year in 2017.  Interest rates were range bound for most of the year, and most bond sectors turned in positive returns. Following the Trump election in late 2016, bonds priced in higher inflation and economic growth, but higher growth and inflation failed to emerge for the most part in 2017.

The 10-year Treasury yield remains right around the level it began 2017, while the 30-year yield is slightly lower now.  Short rates rose slightly as the Fed continued raising rates and the effective Fed Funds Rate moved from 0.55% to 1.16% during the year.

This has led to flattening of the yield curve throughout 2017.  The reduced difference between longer-term and shorter-term Treasury yields reflects the market view that the Fed will continue raising the overnight target rate, pushing short yields higher.  However, longer maturity yields remain range bound influenced by a soft inflation outlook.  The Fed’s December comments reinforced these views with more optimism regarding economic growth in 2018, but no corresponding increase in inflation. This supports our view that monetary policy will remain accommodative and a benign rate environment should support economic growth.    

Don’t Bet Against Bonds

Our general view of rates remains somewhat unchanged.  We believe short rates are poised to continue rising, but think longer-term rates will remain stubbornly low, with very low likelihood of much higher inflation over the next 5 years.  We are somewhat cautious for bonds in the near-term, but still not as concerned as bond perma-bears would have us believe.  The negative sentiment towards bonds from the media and some pundits, which are largely based on market myths & misunderstandings, have kept an unfortunate number of investors from being involved in what continues to be a beneficial & profitable asset class.  As stocks and other risk assets rise in value, we think bonds, despite low rates, are an even more important diversifying asset class despite their low(ish) return expectations going forward.

Federal Reserve: Chair Yellen’s Final Act

The Federal Reserve (Fed) raised the fed funds rate by 25 basis points (0,25%) to a range of 1.25% to 1.50%, the third hike in 2017.  The Fed cited solid economic activity and tightening labor markets.  The Fed believes inflation will eventually accelerate toward 2%.  The Fed’s median forecast for the Fed funds rate reflects three 25-basis-point rate hikes in 2018 and tow similar increases in 2019. 

The transition from Chair Yellen to Chair Powell probably won’t affect interest rate policy in the short term.  We expect a continuation of the balance-sheet reduction program and a series of modest, data-driven rate hikes.  More importantly, we expect Fed policy to continue to be very transparent, which should dampen volatility with fewer unanticipated or poorly explained Fed moves.    

How New Tax Law Impacts Municipal Bonds

The new tax doesn’t change the tax exemption of municipal-bond interest, as had been feared by some.  Concerns about the tax exemption for municipal bond interest were unfounded.  Municipal bonds maintain their status as an attractive source of tax-free income.  We believe this creates even greater demand for municipal bonds issued by high-tax states, such as California, New York, and New Jersey, as taxpayers in these states look for ways to minimize federal taxes.   Overall, we think municipal credit quality remains stable, demand is strong, and the municipal tax exemption is safe. 

Here, we think it might be useful to mention historical research that shows past changes in the top marginal tax rate have not had a significant impact on the municipal market. According to a report from Citi Research, the top marginal tax rates for municipal bonds fluctuated in the range of 28–70% between 1980 and December 2016. But the report found no correlation between municipal yields and the top marginal tax rate. This is likely because the average tax rate for municipal bondholders has remained steady, at around 25%, during the period surveyed.    

Investment Implications

• Rising rates doesn’t necessarily mean you will lose money in bonds. In a case of rising rates or low rates, buying the appropriate bonds in a diversified portfolio and within the scope of your risk profile is important. 
• Higher Fed funds rates will most likely affect the short end of the yield curve. Until we see a pickup in inflation and greater wage growth, we expect long rates to remain range bound.   
• We expect to be cautious in our overall bond portfolio positioning, focusing on diversified sources of income across our portfolios and maintaining portfolio flexibility.
• By positioning defensively, we believe we will be better prepared to take advantage of opportunities presented in more difficult market conditions.
• We see U.S. TIPS as offering attractive valuation and diversification versus corporate bonds, and as a valuable hedge in case higher inflation risks amid late-cycle expansion in the US are realized.
• Investment grade and high yield corporate credit aren’t particularly attractive now because of historically lower credit spreads, i.e. the additional yield for corporate bonds is fairly low compared to government bonds. Because of this, credit-sensitive bonds seem vulnerable in the event of a more difficult market environment.  Overall, we believe credit spreads are too tight and investors may not be receiving enough income for accepting credit risk.   As such we will want to be more selective and focus on bottom-up, active strategies instead of broad-based bond index investing.  We want to emphasize short-dated, higher coupon, and default-resistant positions.   
• We see reasonable valuations in both U.S. non-agency and U.S. agency mortgages. They seem to offer relatively attractive yields plus relative seniority in the capital structure, in our opinion.   

Risks to Bond Investors

• With little to no inflation expected, the risk of cyclical inflation overshooting expectations in 2018 are rising. Just a small uptick in inflation could surprise investors.
• Reduction of monetary accommodation turns out to be too much for the economy and markets that have become dependent on low short rates.   

The information and opinions included in this document are for background purposes only, are not intended to be full or complete, and should not be viewed as an indication of future results. The information sources used in this letter are: Jeremy Siegel, PhD (Jeremysiegel.com), Goldman Sachs, JP Morgan, Empirical Research Partners, Value Line, Ned Davis Research, Citi research and Nuveen.