Determining an accurate outlook for the financial markets is never an easy task, but the 2013 bond market outlook is even more challenging than usual. The reason? While nearly all of the factors that helped bond market performance in the past two years remain firmly in place, bond yields are at extremely low levels compared to historical norms. This indicates that yields have less room to fall (and by extension, for prices to rise) than was the case one or two years ago. At the same time, it leaves a greater latitude for yields to rise (and prices to fall) if one or more elements of the fundamental backdrop were to change. Fixed-income investors are therefore looking at one of two scenarios:

• The investment backdrop improves or stays the same. In this case, the overall bond market would likely deliver returns within one to two percentage points of its yield in 2013.
• The investment backdrop takes a turn for the worse. Under this scenario, bonds could have significant downside.

That’s obvious enough. The primary question, of course, is assigning probabilities to these two outcomes. While the first scenario is more likely to play out in 2013 than the second, investors still need to be aware that the balance of risk and reward is much less favorable now than it was coming into 2012. Bonds certainly can continue to provide safety, diversification, and modest levels of income – just don’t expect the same type of outstanding returns we witnessed in the 2011-2012 period. And if the investment backdrop is anything but ideal, fixed income investors could be looking at a very challenging year.

Keep in mind, however, that only very rarely do investment-grade bonds produce a negative return in a given calendar year. From 1980 through 2011, the Barclays Aggregate U.S. Bond Index finished in the red only once, in 1994. The record for high yield bonds is less impressive, but still positive with positive returns in 24 of the 29 calendar years through 2012.

With this said, what factors could help or hurt bonds in 2013?

Factors Supporting the Bond Market

Although the risk-reward trade-off has become less attractive, there are still a number of important positive factors that reduce the odds of a major meltdown for the bond market in 2013:

1) The most important – Fed policy: The U.S. Federal Reserve has that it will not consider raising short-term interest rates until unemployment reaches 6.5% or inflation climbs above 2.5%. In addition, the Fed continues to pursue its quantitative easing program. The tremendous level of support from the Fed makes a major sell-off in U.S. Treasuries unlikely barring a major drop in unemployment or a jump in inflation, which in turn helps support the performance of other high-quality market segments.

It is important to note that the Labor Participation Rate prior to the recession was just below 66%. Today, with more of our working aged population discouraged about their job market prospects, the Labor Participation Rate is now slightly above 63%. If that rate was at the pre-recession level, our unemployment rate would actually be approximately 10.3% – nowhere near the Fed’s target.

2) Low inflation: Inflation remains low, and there is no sign of any inflation on the immediate horizon despite widespread concern that the stimulative policies of the Fed will lead to higher prices. There has been a recent sell-off in gold and a variety of other commodities that further diminishes the probably of heightened inflation in the near term.

3) The slow growth environment continues: Economic growth remains thoroughly stagnant, and with higher taxes on tap for 2013 there is little to suggest that it will accelerate from its current rate in the 1-2% range. (Stronger economic growth makes the Fed more likely to raise rates, which hurts bond prices, while slower growth does the opposite).

4) Investors’ continued search for yield: The “spread sectors” of the bond market – in other words, the non-Treasury segments that trade based on their “yield spread” (or advantage) over Treasuries – should continue to find support from investors’ search for higher-yielding alternatives to the safer areas of the market. This has been – and given the Fed’s low-rate policy – a positive factor supporting corporate, high yield, and emerging market bonds. At the same time, municipal bonds are likely to perform well in any environment since taxes are likely to go up no matter what the final outcome.

5) Baby Boomers can’t stomach another major correction: The 78 million baby boomers just began to hit retirement age starting last year. As this extremely large segment of our society beings to moderate their consumption and shift into more of a saving mentality, the velocity of money – the rate of which money changes hands, a key indicator of inflation – will continue to be subdued. Also, these boomers may be quite leery of placing large portions of their portfolios at risk in the equity markets given the 2 major corrections and the flash crash that traumatized countless investors recently. Other than shoving the money into the mattress, fixed income securities will still likely be a desired home for their more conservative capital.

What Could Go Wrong for the Bond Market?

1) Higher-than-Expected Inflation: Of the five pillars of support laid out above, the one with the greatest likelihood of producing a negative surprise in 2013 is number two – inflation. While the current annual headline inflation reported by the government is fairly tame at about 2% or less, the Federal Reserve and other global central banks have been pumping money into the global financial system in recent years. The reason this could cause higher inflation is simple: a higher supply of money is chasing essentially the same amount of goods and services, which in theory should drive up prices. This scenario hasn’t yet played out due to sluggish economic growth, but there is a strong chance that it could in the coming years. Once it does, Treasury yields will begin to climb in anticipation of tighter Fed policy, and the bull market in bonds will likely unravel. If this happens sooner than expected, bonds will suffer accordingly. Again, this is not the most likely scenario, but rather the most important risk factor to consider.

2) Adverse Policy Developments: While the fiscal cliff has been resolved, U.S. lawmakers still have to vote to raise the debt ceiling. Investors expect the issue to be resolved – albeit at the last minute – and any failure to do so would cause higher-risk assets to decline in price, but it would likely boost Treasuries and Treasury Inflation-Protected Securities (TIPS) but cause corporate, high yield, and emerging market bonds to lose ground. Again, however, the likelihood of a worst-case scenario is small, and the issues should be wrapped up sometime in the first calendar quarter.

3) Unforeseen Risk Factors: The two issues above are “known unknowns,” as Defense Secretary Donald Rumsfeld once put it. This leaves the “unknown unknowns,” or risk factors that come out of the blue. Examples would be a sudden and surprising deterioration of the Chinese economy, a worst-case scenario emerging from the European debt crisis (such as a collapse of the eurozone), or a severe downturn in the global equity markets. Typically, these types of issues benefit U.S. Treasuries but weigh heavily on higher-risk market segments such as high yield and emerging market bonds.

Bonds Becoming Less Competitive Vs. Stocks

The other issue with the potential to impact the bond market is the flood of investor cash that has moved out of stocks and into bonds in recent years. Absolute yields are so low that it has become almost mathematically impossible for bonds to replicate their recent returns. Stocks, meanwhile, offer investors competitive dividend yields and the potential for earnings growth. As a result, a surprising improvement in the economic outlook could attract capital away from bonds and into equities. Since 2009, over $1.1 trillion has flowed into bond mutual funds while domestic equity funds have experienced a net $400 billion outflow.

The Bottom Line

Naturally, nobody knows what surprises will emerge in the year ahead. But one thing is certain: with bond yields so low, the potential impact of adverse headlines is higher than usual as we move into 2013. Put it all together, investors should expect the following from the bond market in the year ahead:

• Continued low yields
• Higher volatility
• Lower price appreciation than we’ve seen in recent years, but with returns within one to two percentage points of current yields

How to Manage this Environment

South Coast feels the most prudent approach to managing your fixed income portfolio in the current environment is to reduce your exposure to longer dated maturities and seek out professional portfolio strategists that have experience managing fixed income investments in a rising rate environment. Tactical portfolio managers that look at the markets over the intermediate duration attempt to analyze the relative risk in the various sectors of the bond markets over the near term. If the near term risk of price declines outweighs the potential rewards, the manager has the ability to reduce bond exposure with the goal of protecting against or reducing any potential losses. If the market swings back into favor, they can then redeploy the capital into the bond markets.

The biggest challenge that investors face today is all of the “noise” that constantly surrounds us. If you feel yourself constantly second guessing your decisions or simply unable to make any decisions because the contradicting information is paralyzing, please reach out to South Coast so that we can develop and implement a fixed income strategy that is right for you.