• Investment Management

For Bonds, the Economy Is “Just Right”

Concerns about a bond bubble in U.S. credit are overblown when the economy is growing so slowly, say fixed-income managers at Morgan Stanley.

What's not to like in the U.S. credit markets this year? High-yield bonds have returned 16.5% year-to-date1, and investors who bought the debt of companies in the S&P 500 Index have done far better than those who bought their stocks2.

But what about 2017? It’s hard for investors to imagine a repeat of this year’s bond bonanza, and talk of a bond bubble has emerged, as consensus grows for a Federal Reserve rate hike in December. Another concern is the possibility of rising inflation, as oil prices recover. 

While all that might be true, Jim Caron and Richard Lindquist, both fixed-income investment managers at Morgan Stanley Investment Management, don’t believe that a bubble-bursting scenario is around the corner. Although it’s highly unlikely that total returns will be as robust next year as in 2016, the economic backdrop still favors bonds, they argue.

Just Right

“With growth chugging along at around 2% a year,3 I believe the U.S. economy is neither too hot nor too cold, but just right for bond investors,” says Caron, portfolio manager of the Global Fixed Income Opportunity fund. “If the Fed continues raising rates at a slow pace, which is the market consensus, then bonds are unlikely to move drastically in one direction or the other.”

In a “just right” world, bonds could still play a meaningful income-generating role in retail investors’ portfolios. “Retail investors can buy and hold certain bonds that have the potential to produce income from coupon payments,” says Caron.

Caron believes that, for those investors willing to assume a greater degree of risk, U.S. high-yield bonds offer attractive income-generating opportunities and that this year’s rally in emerging-market debt still has room to run. He also favors residential and commercial mortgage-backed securities, as the U.S. economy continues to grow.

Lindquist, who runs the high-yield team at Morgan Stanley Investment Management, has a positive outlook on the U.S. high-yield market for the year ahead. Although U.S. high-yield has rallied almost 22% this year, from lows of negative 5.16% in February,4 the markets’ supply and demand technicals are still strong, he says. This year is on track to match 2015’s $262 billion high-yield bond issuance,5 but it’s been easily absorbed by steady fund inflows since the second quarter.

The fundamental health of the high-yield market has also improved this year, not only because of rising energy prices, but also due to the proliferation of new bond issues to refinance high-cost, shorter-dated bonds, with longer-dated, lower coupon securities.

Yield Levels for U.S. Corporate Credit and Government Debt.

Index definitions can be found in the disclosure section.

Past performance is not indicative of future results. Provided for informational purposes and should not be deemed a recommendation to buy or sell any security. The index is unmanaged and it is not possible to invest directly in an index. The views and opinions are those of the Team as of the date of the presentation and are subject to change at any time due to changes in market or economic conditions.

Source: Morgan Stanley Research, Citigroup Index LLC, Bloomberg LP

Demand should also keep coming, thanks to negative interest rates in Japan and much of Europe. “The U.S. high-yield market is probably fairly to slightly rich at this point, but we have continued to see inflows because people don’t have many places to put their money to potentially earn real yield. There’s U.S. high-yield bonds and emerging-market debt,” says Lindquist.

Oil prices, rather than a Fed rate hike, will make or break the U.S. high-yield bond market, Lindquist argues. It was crude oil’s plunge to $26 a barrel in February that caused high-yield bonds to tank in the first quarter, and its recovery since then to around $506 has fueled its rally.

“If oil starts to fall again, default rates will likely tick up and cause another sell-off in high yield. Conversely, if oil continues to go higher, that will likely be positive for the asset class,” says Lindquist.

U.S. High-Yield Bond New Issue Use of Proceeds.

Index definitions can be found in the disclosure section.

Past performance is not indicative of future results. Provided for informational purposes and should not be deemed a recommendation to buy or sell any security. The index is unmanaged and it is not possible to invest directly in an index. The views and opinions are those of the Team as of the date of the presentation and are subject to change at any time due to changes in market or economic conditions.

Source: Barclays Research

The overall default rate in U.S. high-yield bonds has jumped to about 5.4%this year, but mostly because of defaults in the Energy sector, and to a lesser degree Metals & Mining. Out of about 44 defaults in the U.S. this year, 31 have been by commodity-related companies. The rest of the market still has the same default rate level it’s had for the past several years, at around 2.5%.8

All bets are off, however, if the Fed starts to push rates up more than the market expects.

Caron advises investors to keep an eye on the 10-year Treasury yield. A bearish sign would be if it rises above a yield of 2.00%. In the final week of October, the 10-year was trading at 1.79%, from an historic low of around 1.4% in July8 and almost 2.3% at the end of 2015.

“The key is how fast that adjustment phase happens. It will be bad for total returns on fixed-income investments if it’s an aggressive shift upwards.”