With all due respect to the men’s and women’s basketball teams at the University of Connecticut, the real March Madness winners were fixed income investors. In the first quarter of 2014, taxable and tax-free bonds provided total returns of 2.87% and 3.85% respectively (source: Bloomberg). Similar to a good basketball game, there was lots of back and forth during the quarter, but in the end the quality names prevailed.
The first quarter began where 2013 left off. The U.S. Federal Reserve continued to “taper” Quantitative Easing (QE), and Treasury yields finally stabilized after seven months of steady increases. The consensus forecast early in the year was that the Fed would be done with QE by the end of 2014, and we would see a rise in the Fed funds rate by late 2015. There was no doubt in anyone’s mind that interest rates were headed up. The only question: How high? However, as is the case with nearly all market-moving events, a series of unforeseen political and economic upsets blew up everyone’s bracket.
The turmoil in the Ukraine, less-than-stellar growth in China, and hardship in the emerging markets all conspired to boost bond prices during the quarter. As these uncertainties mounted, they forced a flight from risk, which drove up the prices of both U.S. Treasuries and domestic investment-grade bonds. New Fed Chair Janet Yellen attempted to dampen some of the bond market enthusiasm with her infamous “six months” comment, referring to the time interval between the end of tapering and the beginning of formal interest rate increases. Markets quickly shrugged it off as a mere technical foul on her part, and the “risk-off” trade continued. Ongoing weakness in the U.S. economy and higher than normal domestic unemployment made even more investors question the growth consensus. By the end of the quarter, very few economists believed that the Fed would raise rates anytime soon. The consensus had come full circle. Raising interest rates “six months” after the completion of QE does not even seem to be an option at this point.
Another driver of the recent rally in fixed income is the unwillingness of investors to part with their bonds. According to MarketAxess, an electronic bond trading platform, traders trying to purchase bonds are only successful 46% of the time, while investors trying to sell their securities succeed at a rate of 85%. This tells you the bond market remains very much a seller’s market, with bidders forced to pay that little bit extra just to get a transaction done. This mismatch has sent risk premiums, which represent the extra amount of interest you get paid to take credit risk, down to the lowest levels since 2007, prior to the credit crisis. Whether it’s geopolitical issues, lack of supply, or both, the result has been higher bond prices so far in 2014. Both investment grade corporate bonds and municipals have already recouped their 2013 losses and then some.