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2012 Bond Market Outlook

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Click here for the 2013 Bond Market Outlook.

Click here for a review of 2012 bond market performance.

Assessing the 2012 bond market outlook presents a challenge for fixed-income investors, since so much hinges on the evolution of the European debt crisis. For most investors in bonds and bond funds, performance in the year ahead may well be determined by events that unfold half a world away. For a preview of what 2012 may hold for the bond market, we therefore must first consider the outlook for Europe.

Europe: Setting the Pace for U.S. Bond Market Performance in 2011… and 2012

Why is the outlook for Europe so important? The daily news flow out of the European continent was the primary driver of bond market performance throughout the second half of 2011. When the news was discouraging – fueling fears about a potential government default, the development of a banking crisis, and even a possible break-up of the euro – investors typically responded by staging a “flight to quality” into U.S. Treasuries. Bad news from Europe also typically led to poor performance for higher-risk areas of the market, such as high-yield bonds and emerging markets debt. The converse was also true: good news typically brought weaker performance for U.S. Treasuries and rallies in higher-risk investments.

Click here for 2011 bond market return data.

U.S. Treasuries: Rock-Bottom Yields Leave Little Room for Improvement in 2012

The result of the flight to quality is that the yield on the 10-year note fell to record lows in 2011 as its price rose. Although at various points five- and ten-year Treasury notes yielded less than 1% and 2%, respectively, the quest for safety outweighed the prospect of beating inflation or earning a meaningful long-term return.

For yields to stay at these ultra-low levels, there will likely need to be a continued deterioration of the situation in Europe. Without the need for safety, after all, why hold an investment that pays next to nothing? Keeping in mind that good news for the economy is typically bad news for U.S. Treasuries, another potential risk for the government bond market is a better-than-expected improvement in economic growth in 2012. Any uptick in inflation from its current low level also would be a negative, since rising inflation has a negative impact on bond prices. While the Treasury market will continue to have the support of favorable U.S. Federal Reserve policy, it appears that more can go wrong for Treasuries in 2012 than can go right. Caveat emptor.

Municipal Bonds: Attractive After-Tax Yields

The municipal bond market continues to face the dual headwinds caused by the need for spending cuts among U.S. government entities and the upcoming election in the autumn of 2012. However, the yields on high-quality municipal bonds remain attractive relative to Treasuries. For instance, as of December 5 the yield on the iShares S&P National AMT-Free Municipal Bond exchange-traded fund (ticker:MUB) was 3.37%, compared to 2.31% for the iShares Trust Barclays 7-10 Year Treasury Bond Fund (ticker:IEF). Keep in mind, most investors will lose a portion of the income from Treasuries to taxes, while that is not the case with municipals.

Investment-Grade Corporate and High-Yield Bonds: Poised for Outperformance in 2012?

During the second half of 2011, both investment-grade and high-yield bonds have experienced rising yields, and underperformance relative to U.S. Treasuries, due to the broader concerns about Europe. At the same time, however, the underlying fundamentals of U.S. corporations continue to improve: earnings are strong, balance sheets are robust, and many companies are continuing to find room to cut costs. As a result, there’s room for improvement in both asset classes in the year ahead if the situation in Europe show signs of improvement. The British asset manager Barclays is projecting 4.5 percentage points of outperformance for corporate bonds, relative to Treasuries, in 2012.

In the high-yield sector, meanwhile, yields typically track the rate of defaults (or in other words, the percentage of companies that fail to make interest or principal payments on time). The default rate has been below 2% throughout 2011 and is expected to remain so in the year ahead, yet the two largest exchange-trade funds – iShares iBoxx High Yield Corporate Bond Fund (ticker:HYG) and SPDR Barclays Capital High Yield Bond ETF (ticker:JNK) – were yielding 7.54% and 7.75%, respectively, as of December 5. As a result, investors can collect yields comfortably ahead of government bonds while still having a chance at rising prices if the outlook for Europe improves.

Mortgage-Backed Securities: A Potentially “Cheap” Asset Class

Like corporate bonds, mortgage-backed securities are offering a higher-than-normal yield advantage over Treasuries. The iShares S&P National AMT-Free Municipal Bond ETF (ticker:MUB), was yielding 3.37% on December 5, more than a full percentage point above the Treasury ETF. The global asset manager Credit Suisse has identified mortgage-backed securities as being “one of the cheapest asset classes” in the bond market, and predicts it will perform well in 2012.

Emerging Market Bonds: Risks and Rewards

While emerging market debt is a much stronger, fundamentally sound asset class than it was in the past, it still is highly sensitive to global investor sentiment. Emerging market bonds have lagged Treasuries in 2011 as a result, and they remain vulnerable to further negative news flow out of Europe in 2012. As a result, investors will need to proceed with caution in the months ahead. Still, the fundamental underpinnings of strong performance – namely, the much stronger economic growth of emerging nations compared to their developed market counterparts – means that the emerging markets can perform well if the outlook for Europe improves in 2012. In addition, emerging market central banks have the latitude to cut interest rates in the year ahead – which cannot be said for the United States or the other developed world markets. Despite these positives, the asset class as a whole offers a yield advantage of about three percentage points relative to the U.S. market.

Conclusion

As of this writing, the outlook for Europe remains cloudy. While policymakers appear to have received the market’s signal that a coordinated, longer-term solution is needed, the enormous levels of debt of the region’s major countries leaves open the possibility that we have yet to see the worst of the crisis. Expect the performance of the U.S. bond market to be closely tied to the eventual outcome of the crisis – whatever it may be.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.

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