What can bond investors expect in 2019?
The S&P 500 index is on track for its worst year since 2008, and investors worried that things could go from bad to worse in 2019 are looking for ways to protect their portfolios. With interest rates on the rise, the relative safety of bonds is getting more appealing by the day for long-term investors. LPL Financial recently released its Outlook 2019 report, which includes an entire chapter on what investors can expect from the bond market next year. Here is a summary of LPL’s expectations for seven different classes of bonds in 2019.
LPL says U.S. interest rates will continue to rise at a moderate pace in 2019, making high-quality bonds more attractive for long-term investors. LPL says U.S. Treasury bonds are extremely sensitive to changes in the fed funds rate, and rising rates could negatively impact total returns. The Federal Reserve is projecting two additional 2019 rate hikes, and LPL is forecasting 10-year Treasury yields to peak between 3.25 and 3.75 percent in 2019. LPL says Treasurys can play an important role in providing diversification, income and liquidity during periods of extreme volatility in the stock market.
LPL says the 2017 tax cuts have hurt demand for municipal bonds, but munis performed better than the firm expected in 2018. Municipal bonds are a great way for investors to generate tax-free income, as all municipal bond interest payments are tax-exempt at the federal level. In addition, municipal bonds pay a premium yield to Treasury bonds, making them a relatively attractive option as long as investors stay diversified. Bond investors should remember that only municipal bond interest is tax-exempt, and any capital gains earned on their face value by selling prior to maturation is still subject to taxation.
The housing market has made a remarkable recovery since the downturn in 2008, and LPL says mortgage-backed securities have historically been extremely strong performers during periods of rising interest rates. Higher interest rates reduce prepayment risk for MBS investors, the risk associated with earlier-than-expected repayment of mortgage principal. LPL says mortgage supply in 2018 has been lower than anticipated, and a flattening yield curve has minimized MBS volatility. Even if the Federal Reserve slows the pace of its tightening in 2019, LPL says MBS provide an added dimension of diversification to a long-term portfolio.
Investment-grade corporate bonds
High-yield bonds have historically provided better returns than investment-grade bonds during periods of rising interest rates. However, LPL says investment-grade bonds are a safer way to get added credit exposure while also protecting your portfolio from the risks associated with lower-quality corporate debt. LPL says half of the U.S. corporate bond market now has a credit rating of BBB. These BBB-rated bonds are one notch above high-yield status and are somewhat of a middle ground for investors. As a result of the mass of BBB-rated bonds, LPL says investment-grade yields may be higher than their historical average in 2019.
High-yield corporate bonds
LPL says the high-yield bonds could continue to be supported by U.S. economic growth, but the potential for an economic slowdown has created meaningful risk in the high-yield market. According to LPL, a modest high-yield bond position is fine for diversification purposes, but the firm prefers a combination of investment-grade corporate bonds and high-quality stocks. The iShares iBoxx High Yield Corporate Bond ETF (ticker: HYG) outperformed the iShares iBoxx Investment Grade Corporate Bond ETF (LQD) throughout most of 2018, but the trend reversed in November, suggesting a potential shift toward higher-quality debt in 2019.
In the bank loan market, LPL says high issuance and softer investor protections are potential red flags for investors. Bank loans have historically been less volatile than high-yield bonds, but the bank loan market has also historically been less liquid. Like high-yield corporate bonds, bank loans can provide a level of diversification for investors, but the below investment-grade credit risk offsets much of the benefits bank loans provide in protecting against rising interest rates. LPL prefers bank loans to high-yield bonds in 2019 but says investors should limit their exposure to both markets in an uncertain environment.
LPL says developed market sovereign bonds are overvalued, as central bank policies around the world have generally kept yields unattractive. Less accommodative central bank policies could create a difficult environment for bond investors in 2019. At the same time, LPL says emerging market debt currently has a relatively attractive valuation compared to its historical levels, and the firm is anticipating a rally in emerging market bonds over the next several quarters. A potential end to the international trade war could also be a bullish catalyst for emerging market bonds in 2019.
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