A Rough Start

For bond owners, 2018 is off to a poor start.  Virtually every market sector has posted negative YTD returns.  The 30-year Treasury bond has a YTD return of -7%, the investment grade corporate market return is -2.4% and the municipal market return is -1.5%.  TIPS have returned -1.9% and even the high yield corporate market posted a return of -0.3%.  High yield continues to be the best performing sector, as it was in 2016 and 2017.

The relatively poor performance of the investment grade corporate market might be the biggest surprise this year.  That market had been consistently outperforming Treasuries until last month.  With greater interest income, those corporates should resume posting better returns than Treasuries in the months ahead.

Munis continued the pattern of outperforming Treasuries that began last year.  The muni market could have even weaker supply calendars in 2018, now that advance refundings are no longer possible.  Muni-Treasury yield ratios have already declined to near the pre-crisis ranges, and seemed destined to drop even more this year.

One should never forecast with a straight-edge, but Chairman Powell seems very comfortable with at least three rate increases this year.  By this time next year, the funds rate could be 2 1/4%-2 1/2%.  In that event, the yield on the 10-year Treasury note would probably be around 3.50%.  What does that imply for total returns over the next 12 months?

Returns from Treasuries and high grade munis maturing beyond five years would very likely be negative.  Returns from BBB munis with maturities of 10 years or less could be positive.  Returns on A/BBB corporates with maturities of 10 years and shorter are likely to be positive–perhaps in the 2-4% range.  Spreads are sufficient to allow yields on those credits to rise no more than, and possibly somewhat less than, yields on comparable Treasuries.  If so, the better coupon income would be enough to produce positive returns.

This type of scenario analysis still favors high yield by a substantial margin.  The spread between the yield on the high yield index versus the yield on the Treasury index is around 350 bps–at the bottom of the range that is typical for this stage of the economic cycle.  That spread could, however, narrow some if the economy performs well.  In that event, the high yield market might be expected to produce total returns in the range of 3-6% over the next 12 months.

While the rest of 2018 might not be as negative for bonds as January-February, the ranking of YTD returns might be a useful guide for the months ahead.  Avoid the longest duration segments–the short-to-intermediate maturities have a much better chance of producing positive returns.  Accepting credit risk rather than duration risk is still the preferred strategy.

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