In 2013 we saw moderate economic growth while the Federal Reserve maintained their quantitative easing program. This was something that kept short-term interest rates low but still the Fed’s general attitude was something that made most investors a bit nervous and inevitably hurt many bond portfolios due to the rise in long-term rates.
What this showed many investors is that forecasting the market is as much about investor sentiment as it is about data analysis. Indeed, as they continued to be active with their QE program last year it became clear that what the Fed was saying was nearly as important as what they were doing, a theme that will more than likely be quite significant in 2014
Which leads to the question of what’s likely going to happen with the bond market in 2014. In all likelihood we’ll see the same slow growth as the markets continue to be policy driven. 5+ year bonds will more than likely see their rates go higher as the federal government’s bond buying program is tapered down. Most experts are predicting that the Funds rate will remain zero in 2014, something that should help anchor short-term fixed income yields. Volatility will more than likely be a theme again in 2014 and, in most likelihood, inflation should maintain its historically low course.
All of which leads to three strategies for bond investors in the next 12 months.
- Shorten the duration of your fixed income portfolio. In 2013 one of the best strategies was duration rotation, whereby investors who anticipated a rise in rates shortened the duration of their portfolios in response. The fact is that Treasury rates, based on current growth levels and inflation, are rapidly approaching their fair value. Unless either inflation or growth have a large spike in the coming year the rate increase in 2014 will be a bit more modest than it was last year.
- Invest in short duration bonds rather than cash. Right now investors are getting a negative real return on their cash investments (after they factor in inflation) because of near zero short-term interest rates. Even though cash is definitely the safest investment, bonds of short duration are relatively low risk but offer the opportunity of a much higher yield overall than cash. You can expect that short duration ETF’s will be used by many investors this year as they continue to get their feet wet in the market again.
- Consider investing (with caution) in municipal bonds. On a tax adjusted basis municipal bonds are still very attractive, especially in a market where finding yield is becoming more and more difficult. Keep in mind however that they are highly rate sensitive.
Of course before you choose any type of fixed income strategy you should always consider the exact role that bonds will be playing in your portfolio. Consider whether you are seeking yield, stability or diversification and keep those objectives in mind with all of your bond investments. If you do that, 2014 should prove to be a very good year.