Fixed-income managers may disagree about whether the bull market is over for bonds, but the backdrop they sketch for the bond world is similar.

Interest rates are finally likely to rise, which will harm current bond valuations. There’s also global uncertainty, especially about the policies that will eventually be pursued by President Donald Trump. A period of market volatility is expected to ensue as some of the post-election fairy dust starts to settle.

All these factors will combine to create an even more unstable world for U.S. bonds.

In December, the Federal Reserve hiked the federal funds rate by 25 basis points. It was only the second increase since 2006. The Fed anticipates tightening rates three more times in 2017.

Loomis Sayles Vice Chairman Dan Fuss believes that the period of near-zero interest rates that characterized the world after the financial crisis is over. But what comes next isn’t clear.

Some think the reflation trade could occur quickly, taking 10-year Treasury rates to 5% or 6% in 12 to 24 months from the year-end 2016 level of 2.45%. Fuss calls that sort of hike a stretch, but says it could indeed be more possible one or two cycles down the line.
“In other words, the long-term direction of interest rates is now up,” he says. “How long and how far is impossible to determine.”

It’s also impossible to know whether the ride will be smooth or bumpy. James Meyers, director of fixed-income strategy at PowerShares, notes that after the increase in rates following the November election, markets are taking a “wait-and-see approach.”

Like Fuss, he believes that predictions of 5% to 6% in 10-year Treasury yields in the next 24 months are unlikely to come to pass. Were that scenario to occur, consumer spending and the mortgage market could experience destabilization. There could also be political reactions and consumer pushback.

Meyers says investors who play it right will be able to collect higher income and that will allow them to preserve most of their capital as prices decline amid higher interest rates. The sweet spot of the bond market is likely to be found in the two- to 10-year “belly of the yield curve” in so-called spread products like investment-grade and high-yield bonds, as well as in bank loans and preferred stocks. Even if rates rise and Treasury bonds lose value, as expected, these “spread products” may benefit from a stronger economy and could thus see their principal retain more value than Treasurys do.

Since the U.S. presidential election, “the markets have priced in a significant and permanent rise in the expected level of economic growth and inflation for more than a decade into the future,” says Robert Tipp, portfolio manager for the Prudential Total Return Bond Fund. It’s a possible scenario, “but is that a reasonable base case for the markets to embrace?” he says. “Probably not.”

“We don’t really know at this point what the approach and the chemistry of the lawmakers and the president is going to be,” he says. “We’re going to have to see what exact policies come to the fore and where the rubber meets the road in Washington D.C.—and how things are shaping up in the rest of the world.”

Andy Chorlton, head of U.S. multisector fixed income at Schroders and a manager of the Hartford Schroders Tax-Aware Bond Fund, also questions investor sentiment in the aftermath of the election. “Pretty much since then, it’s been a one-way train—buy equities, sell bonds,” says Chorlton. “It feels like the market is ignoring everything and only focusing on the positive.”

He thinks there may be a bit of a pause in the markets early this year as investors begin to question valuations and focus on the policies that Donald Trump will actually implement—rather than just bandy about—to boost economic growth and inflation. It might also be challenging to seamlessly implement those policies because “the new administration is somewhat untested in the political theater,” he says.

Kathleen Gaffney, co-director of diversified fixed income at Eaton Vance and lead manager on the Eaton Vance Multisector Income Fund, thinks “it’s highly unlikely that a year after Trump is in office we’re going to have gained enough insight to know what to expect from his administration.”

“Trump is unorthodox, and this type of president is unprecedented,” she says.

Between political uncertainty and rising interest rates, “it’s going to be a very challenging environment for plain vanilla fixed income that most investors tend to associate as a very safe asset class,” she adds. She worries U.S. Treasurys and government bonds could offer negative returns. “I’m really scouring the market for the best ideas,” she says.

A Closer Look
Tipp says the two main variables affecting fixed income are the way trade and the federal budget are going to be handled. Candidate Donald Trump spouted a lot of protectionist rhetoric while on the campaign trail, but Tipp and Gaffney think the new administration will put some of this on the back burner, at least initially, so it can focus on expanding rather than restraining economic growth.

Tipp anticipates some tax cuts and some increased spending. “It’s not going to be an unbridled version of what Donald Trump had proposed,” he says, “but it will not be as restrained as some of the previous budgets put forth by [Congressman Paul] Ryan and the House in recent years.”

Tipp expects the budget will be stimulative and likely a net positive for economic growth over the next 12 to 36 months. However, “so far, we don’t have any reason to believe there’s going to be a significant, permanent increase in the rate of economic growth,” he says. “After the temporary impact of the stimulus subsides, we’ll still be left with the issues currently facing all developed and many emerging economies such as aging demographics, high levels of indebtedness and declining productivity.”

Meanwhile, the splintering of political parties across Europe is making it more difficult for European leaders to effect policy that would boost growth, he says. “But Europe’s muted growth and inflation backdrop is likely to translate into a positive for global bond markets,” Tipp adds, as could a potential economic slowdown in China.

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