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Encore! Encore? 2019 a tough act to follow

  • Robert Ostrowski

    Chief Investment Officer Global Fixed Income

It was a really good year for fixed income. 2020 may prove more challenging.

If we were to just describe our economic outlook for the next 12 months, it would sound a lot like it did a year ago: moderate GDP growth, modestly increasing inflation and an accommodative Fed. But when it comes to performance, 2019 is going to be a tough act to follow. Indeed, it was one for the books. As measured by the 8.72% total return for Bloomberg Barclays U.S. Aggregate Bond Index (or the Agg), 2019 was fixed income’s best year since 2002.

Why might this year be more challenging? In a word, valuations. Interest rates are running 50 to 100 basis points lower across the yield curve than they were a year ago. As an example, the yield to maturity on the Agg fell from 3.30% on Dec. 31, 2018, to 2.34% on Dec. 31, 2019. At the same time, the spread between investment-grade (IG), high yield (HY) and emerging market (EM) credit and comparable maturity Treasuries has narrowed 100 basis points to near cycle lows. So while the year’s second half may be dominated by the U.S. presidential and congressional elections, this struggle with low valuations likely will dominate the first half, with the low starting point for rates cutting into income’s contribution to total returns and the tight spreads raising the odds price returns could turn negative.


Against this demanding backdrop, for the first time in a decade Federated is starting a new year underweight both IG and HY bonds. Even though we don’t expect a recession and think growth may perk up as the year progresses, it’s simply difficult to be constructive on credit when prices are so high and yields are so low. Strip out the small but riskier “high-yield tail,” consisting primarily of energy, commodity and pharmaceutical components of the HY benchmark, for example, and you’re left with spreads in the low 200s and yields under 4%. Not much upside from there. We also have eliminated our EM overweight but are sticking with a neutral position as we expect a stronger global economy and reduced trade tensions will lift commodities.


As an offset to our credit underweights, we have shifted to overweight Treasury Inflation-Protected Securities (TIPS), which should benefit if inflation picks up as we think it will. Nothing major, but we’ve already seen consumer prices settle above 2%, and it’s not out of the realm to think the Fed’s preferred PCE Index may follow suit. Policymakers have said this is their preference and indicated they won’t pre-empt such a move. Elsewhere, we are positioned for a steepening yield curve and are slightly short duration. Again, nothing dramatic, just enough to add alpha if rates rise as anticipated.

Most years, either rates or credit spreads dominate, but in 2019, both contributed and moved in favor of bondholders.


It wasn’t so much that the fixed-income market’s high absolute returns were unheard of, but rather that rarely do the highest quality and lowest quality sectors achieve significantly above-coupon total returns in the same year. Most years, either rates or credit spreads dominate, but in 2019, both contributed and moved in favor of bondholders. In this environment, many active managers outperformed their respective benchmarks by going long on duration as Treasury yields trended down most of the year and by remaining slightly overweight in credit as spreads continued to narrow.


Also surprising was fixed-income’s strong finish to the year. Under our process of using multiple alpha sources to add value in fixed income portfolios, we reduced virtually all of our strategic bets in the fourth quarter and relied instead on security selection and a series of small tactical bets related to yield curve, currency and TIPs.

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Alpha: This measures a fund’s risk-adjusted performance. It represents the difference between a fund’s actual returns and its expected performance, given its level of risk as measured by beta (see definition of Beta). This difference is expressed as an annualized percentage.

Bloomberg Barclays U.S. Aggregate Bond Index: An unmanaged index composed of securities from the Bloomberg Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indices are rebalanced monthly by market capitalization. Indexes are unmanaged and investments cannot be made in an index.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Diversification and asset allocation do not assure a profit nor protect against loss.

Duration is a measure of a security’s price sensitivity to changes in interest rates. Securities with longer durations are more sensitive to changes in interest rates than securities of shorter durations.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risks and may be more volatile than investment-grade securities.

International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging-market and frontier-market securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.

Personal Consumption Expenditure (PCE) Index: A measure of inflation at the consumer level.

Yield Curve: Graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.

Yield to Maturity (YTM) is used to determine the rate of return an investor would receive if a long-term, interest-bearing investment, such as a bond, is held to its maturity date. It takes into account purchase price, redemption value, time to maturity, coupon yield, and the time between interest payments.

Federated Investment Management Company