What a difference a year makes when it comes to expectations versus reality. Case in point: at the end of 2013, most interest rate strategists expected 10 year Treasury rates to rise to the 3.5% to 4.5% range over the course of the year. Clearly they were mistaken. Instead, bond yields surprised many investors by falling instead of rising. The 10 year actually declined quite significantly, from 3.02% to 2.17%. Here’s why: throughout the year, the Fed “tapered” its purchases, ending its quantitative easing (QE) program in October 2014. With the Fed no longer actively buying Treasuries, some speculated that the end of QE would push interest rates higher. Instead a deceleration of global growth and inflation, along with rising concern about Greece’s membership in the European Union, drove interest rates down. This flight to quality movement also impacted credit spreads, which widened for both investment grade and high yield corporate bonds, negatively impacting the returns of bonds in those sectors.
Falling rates pushed the poor performers of 2013 – namely long duration, municipals, and emerging market debt – into positive territory in 2014, as shown below. Many investors moved to short duration exposures in 2013, but returned to core fixed income in 2014 as markets became choppy and longer duration investments outperformed. For example, iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG) had $7.4 bn of inflows during the year. This made AGG one of the biggest bond ETF asset gatherers in 2014. And the biggest winner of all? The Barclays 20+ Year Treasury Bond Index (NYSEARCA:TLT), returning 27.48% and more than making up for its poor performance in 2013.
So what are some of the things that investors can take away from the 2014 fixed income markets?
- It is really hard to predict interest rates, even for the professionals. Being too tactical with interest rate calls may cause you to miss out on returns.
- Be clear about the role that you want your fixed income investments to play in your portfolio. If you have an investment like AGG that is a long term holding to provide overall portfolio diversification, then it may not be best to adjust your position according to interest rate views. It’s hard to get the call right, and if the investment is there for diversification and stability, you may not want to use it to chase returns.
In my next post, I will discuss how we can apply the lessons learned from our 2014 observations to a 2015 investing strategy.