“The boundaries of uncertainty have increased [for fixed-income markets],” says Dan Ivascyn, chief investment officer at Pimco, the bond specialist that invests more than $1.5tn. “Rates certainly can go higher.”
What is clear for bond investors is that they face a true test of their convictions in 2017 after an end to 2016 that challenged the consensus of low inflation and rates that, at one point, drove yields on nearly $14tn of debt into negative territory.
Indeed, the scale of the turnround in the US bond market in 2016 is underlined by the benchmark 10-year note plumbing a nadir of 1.32 per cent in July, as the 35-year bond bull market set new records, and subsequently climbing to 2.60 per cent this month as Donald Trump’s surprise victory raised the prospect of faster economic growth and higher inflation.
Investor flows in recent weeks have confirmed a pronounced rotation out of bond funds into record-setting US equities.
However, for all the gloom cloaking prospects for bonds in 2017, no one, including policymakers at the US Federal Reserve, has a strong handle on the outlook for the economy and inflation under the fiscal priming promised by Mr Trump.
Yet as yields on US sovereign bonds have risen, fixed income investors who need to stay in the debt market have shifted money into corporate paper, particularly that sold by junk-rated companies on hopes that tax reform and faster economic growth will improve their bottom lines.
The rebound in the oil price from its low in January has buoyed the high-yield corporate bond market and, for strategists at Goldman Sachs, made high-yield energy bonds a top pick for next year despite the stellar 37 per cent return in 2016.
Defaults by energy companies are expected to moderate in 2017 as bankruptcies recede.
Fitch this week projected that the trailing 12-month US high-yield energy default rate would fall to 3 per cent by the end of next year from 18.8 per cent in November.
Overall, the US high-yield bonds have returned more than 16.5 per cent this year, its best annual performance since 2009, when the US emerged from the financial crisis.
Those investors moving into US corporate bonds may also benefit from a potential shrinking in supply. Mr Trump has proposed doing away with the tax deductibility of net interest expenses, which would remove an incentive for companies to tap the debt market.
Bank of America strategists say that cuts to certain tax benefits could reduce the size of the high grade corporate bond market by more than a tenth, or roughly $830bn over time. That is likely to suppress yields and bolster bond prices if the overall debt supply declines, BofA notes.
“Interest rates should rise in 2017 but only at a modest pace due to sluggish global growth and very cautious global central banks,” says David Kelly of JPMorgan Asset Management. “Investors may want to be long credit and short duration in their fixed income allocations.”
One major question for any investor rotating into corporate bonds is at what level yields on benchmark Treasuries have to rise to before they have wider, testing reverberations across the debt market.
Strategists and investors have turned increasingly bearish on Treasuries. The sell-off in US government debt quickened after the Fed last week projected a faster pace of rate rises than markets had expected, flattening the yield curve and revitalising the so-called reflation trade.
Global bond funds have counted more than $36bn of redemptions since the election as investors pour into US stock funds, according to flows tracked by EPFR.
US equity funds have been flush with nearly $60bn of fresh capital since Mr Trump’s election.
David Lafferty, a strategist with Natixis Global Asset Management, warns that “combined with higher growth and fleeing bond investors, interest rates could become untethered in a highly leveraged world”.
The counter view rests on a Trump disappointment trade pricking the optimism over stimulus being a genuine game changer for markets in 2017.
Analysts at BMO Capital Markets forecast higher Treasury yields during the first half of next year “on early optimism that Trumponomics will actually deliver a tangible boost to the real economy”.
However, the bank’s end-of-year target for the 10-year note is 2.25 per cent, reflecting expectations “that the realities of politics in America will limit what fiscal stimulus Trump is ultimately able to push through”.
Treasuries, which returned 3.8 per cent before the US election, have been among the hardest hit. They have declined more than 3 per cent since.
“The US economy is now 90 months into its recovery and US interest rates appear poised to rise further,” he says. “Credit investors should approach 2017 with a dose of caution, even if our base case calls for continued growth, tighter spreads and positive total returns.”
