If inflation does not revert lower, and the Fed allows modest stagflation to develop, Treasury Inflation-Protected Securities (TIPS) may continue to benefit. However, like other segments of the fixed income markets, we do not expect a repeat of a strong first quarter. Still, in a low-return environment, the inflation compensation of TIPS could provide an extra boost for high-quality bond investors as inflation expectations remain very low in a historical context.
HIGH-YIELD
The average yield spread of high-yield bonds dropped to 6.9% at the end of the first quarter—a fair valuation given rising defaults. However, although defaults are increasing, they are still largely concentrated in energy and metals and mining. Even at valuations we find fair, the average yield of high-yield bonds, near 8%, stands out and may be an important source of return in a coupon-clipping environment. High-yield bonds have not shaken their sensitivity to oil prices and the pace of defaults remains an important variable. Despite the potential for some renewed volatility, we believe longer-term investors may be rewarded with a small allocation to high-yield bonds and compensated for risks.
CONCLUSION
The strength in fixed income markets witnessed during the first quarter of 2016 is not expected to repeat. Although recent history shows a significant reversal is unlikely, the remainder of the year may be muted, with the best 2016 has to offer for bonds potentially behind us absent a recession. The Fed and inflation will be key themes to monitor in a coupon-clipping environment where TIPS and high-yield bonds may add incremental value to suitable bond portfolios.
Anthony Valeri is investment strategist for LPL Financial.