‘Modest Gains’ Predicted for Corporate Bonds

While 2013 offered poor returns for investors in corporate bonds, the worst is now over and the year ahead should offer modest gains according to the latest outlook report issued by Morgan Stanley Wealth Management.

MS expects improving economic data to produce a ‘sawtooth climb’ to 3.25% this year for the 10-year Treasury yield, and looks back to two recent periods of rising rates – 1993-94 and 2004-2006 – to gauge how corporate bonds will fare.

MS fixed-income strategists Kevin Flanagan, John Dillon and Jonathan MacKay write:

‘The rate rise in the ‘90s bear market was sudden, with the fed funds rate rising 300 basis points and the yield on the 10-year Treasury rising almost as much in just one year. With little time for investors to adjust, both investment grade and high yield bonds struggled and generated most of their negative returns at the beginning of 1994. In that market, the total return for investment grade bonds was -0.81% and 3.48% for high yield bonds.

In contrast, the 2004-to-2006 cycle was more gradual, as the [US Federal Reserve] telegraphed the rate hikes and raised rates in 25-basis-point increments at every meeting, allowing for a longer period of adjustment for credit investors. As the market grew accustomed to improving economic data and tighter Fed policy, rates moved higher in a more measured fashion and credit spreads gradually tightened. The total return for the two-year bear market: 7.99% for investment grade and 14.60% for high yield. In our view, the current bond selloff appears to be following a script closer to the 2004-to-2006 period.

We believe last year is likely to be the worst year for credit investors of the current interest rate cycle. The path forward should improve somewhat as rates normalise, although the difference in performance between Treasuries, investment grade credit and high yield credit will likely narrow and returns are likely to be lower than previous cycles. In our base case, which calls for a 3.25% yield on the benchmark 10-year Treasury, we estimate investment grade will have a modest return of a little above 1% and high yield will come in the 4%-to-5% range.’

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