Global Fixed Income

Weekly discussion of fixed income market action and what it may mean for investors.

May 23, 2017

Brian Rehling, CFA , Co-Head of Global Fixed Income Strategy

Growing Complacency in Fixed-Income Markets

  • Low yields, muted volatility, appreciating markets and historically low default rates have caused some investors to be complacent regarding U.S. fixed income markets today.
  • A future bond-market correction may have a more significant impact for many investors than they are prepared to face.

What it may mean for investors

  • We recommend that investors globally diversify their portfolios while avoiding excessive concentration in individual credits, fixed-income sectors, and targeted yield-enhancing strategies. It is important to avoid the temptation to reach for yield by over-concentrating allocations in low-credit-quality or long-duration instruments (duration is a measure of interest rate sensitivity).

Low yields, low default rates, low volatility and tight credit spreads have all added to a growing sense of complacency in fixed-income markets. As a result, a future bond-market correction may have a more significant impact for many investors than they are prepared to face today. Periods of asset-class overvaluation often can continue for a significant period of time as capital chases performance and positive sentiment builds.

We find little reason to believe that a correction in U.S. fixed-income markets—either due to a significant and sudden interest-rate increase or a dramatic sell-off in lower-credit-quality debt— is probable in the near term. A number of factors are currently limiting the potential for a major sell-off in fixed-income assets; low international yields, low inflation expectations, and strong investor demand for fixed-income investments.

It is possible that the current environment may continue to persist for a time. We experienced similar periods in the past; from 2004– 2007, credit spreads (over Treasury security yields) remained relatively stable at levels comparable to their current levels. At times, past periods of relative calm and complacency have been followed by significant corrections in asset prices. For example, fixed-income credit markets corrected sharply in 2008—when they were impacted by the financial crisis. More recently, some lower-rated credits temporarily sold off early last year as energy prices tumbled.

Inherent Risks

There are generally two types of risk that may be inherent in many fixed-income investments to some degree.

Interest-rate or duration risk relates to the volatility an investor can experience as interest rates increase or decrease. Longer-maturity holdings generally are more sensitive to changes in interest rates. Since prices fall as interest rates rise, a significant increase in interest rates could cause longer-maturity fixed income investments to correct significantly lower in price. While modest interest-rate shocks may materialize as the Federal Reserve (Fed) normalizes interest rates, we view domestic interest-rate risk as relatively modest over the longer term. Longer-term trends, such as increasing government debt, an aging demographic and low productivity are likely to structurally limit a sustained increase in longer-term U.S. interest rates.

Credit risk represents the added risk an investor assumes by purchasing an issue with lower-credit-quality and/or the likelihood that any issuer will default on its obligation. Historically, there have been a number of events that led to a significant change in the way markets value credit risk. These events have included the:

  • Russian financial crisis in 1998
  • Dot-com bubble in 2000
  • September 11 terrorist attacks and Enron bankruptcy in 2001
  • WorldCom accounting scandal in 2002
  • Subprime mortgage and credit crisis in 2008-2009
  • Greek government debt crisis in 2011
  • Collapse of energy prices early last year

Many of these events occurred with little warning and resulted in a significant negative adjustment in the valuations of fixed-income investments that contained significant credit-risk exposure (such as high-yield debt).

Warning Signs

Rate triggers generally are the result of changes in economic-growth expectations, changes in inflation expectations or unexpected events that lead to a risk-off trade.

An increase in inflation and inflation expectations could occur in the event that the economy improves at a faster pace than has been expected. Should the Fed misread inflationary signals or fail to act in a timely manner, inflation may become a concern to the market. Higher-than-anticipated inflation likely would cause a significant correction in longer maturity fixed-income securities that inherently contain meaningful interest-rate risk. We view such a correction risk as unlikely. More likely would be a continued improvement in global growth that exceeds market expectations, resulting in modestly higher rates. Finally, we do expect periods of risk-off investment behavior that would push rates temporarily lower, but we do not expect such periods to be sustained.

A trigger that may cause the bond market to reprice credit risk is often difficult to pinpoint before an actual event. Such a trigger could come from geopolitical concerns, a weakening economy that makes it more difficult for borrowers to pay back their obligations, a natural disaster, terrorist attack or an event that adjusts market sentiment, such as a major bankruptcy. In our opinion, credit risk to investors is currently heightened given the lofty valuations in the investment-grade and high-yield credit space.

Investor Recommendations

In the current fixed-income environment, investors must guard against complacency. We strongly recommend that investors globally diversify their portfolios while avoiding excessive concentrations in individual credits, sectors or yield enhancing strategies. It is important to avoid the temptation to reach for yield by over-concentrating allocations in low-credit-quality or long-duration instruments. We recommend that investors overweight U.S. intermediate-term fixed income while maintaining a neutral duration profile for fixed-income portfolios. We also view high-yield credit as overvalued and recommend that investors underweight the high-yield debt sector.

Risk Factors

Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.

Investments in fixed-income securities are subject to market, interest rate, credit/default and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Because bond prices generally fall as interest rates rise, the current low interest rate environment can increase the bond’s interest rate risk. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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