2014 proved to be an unexpectedly volatile year for bond investors. As the year began, we saw research reports from every major Wall Street broker-dealer calling for higher interest rates and, in some cases, a bursting of the so-called “bond bubble” that (according to some) has been forming over the past 30+ years. What transpired was something quite different. Longer-term rates fell sharply while short-term rates were mostly unchanged. This dramatic flattening of the yield curve came despite a steadily improving domestic economy, the strongest employment numbers in 15 years and a Federal Reserve that began to publically discuss tightening monetary policy.
So why did interest rates fall despite an abundance of good news that historically causes them to rise? In financial markets, the events and trends that few predict tend to have the largest impact. In 2014, those events emerged in the form of European and Japanese Central Banks failing, despite their best efforts, to avoid the imminent danger of recession and deflation. Weakness in these developed market economies, coupled with geopolitical tensions around the world, caused a classic “flight to safety” trade as global investors sought the safety of U.S. dollar denominated assets. This is clearly illustrated by the performance of the U.S. Dollar during 2014 – see chart below. These developments led to positive performance for our client portfolios, with our Short, Intermediate and Long Duration strategies generating after-fee returns at or above inflation.
DXY Index (source: Bloomberg)
Looking ahead to 2015, we expect another good year for bond investors. As an investment team, we regularly come together to assign probabilities to different market outcomes. The results from our 2015 outlook meeting point to an interest rate environment where longer-term rates are unlikely to stray outside of the range that came to define the second half of 2014. This view is driven by an expectation of continued economic weakness overseas, low inflation here at home and a Federal Reserve that will struggle to move from the zero-bound despite wanting nothing more than to do just that. If this outlook proves correct, positive returns for 2015 should follow. In addition, we are beginning to see value once again in some of our favorite trades. After having underperformed Treasurys during 2014, corporate bonds are again offering attractive risk-adjusted value. We also like taking credit risk in certain sectors of the municipal market as fundamentals for most (stress most, not all) municipalities are on strong footing. Of course, there is a chance that an unforeseen event will rear its head once again. If opportunities arise as a result of market surprises, all of our portfolios have high quality liquid securities that can be used to fund opportunistic trading. At this stage, we are comfortable that our portfolios are well positioned for the New Year.