Download Gradual Return to Normalcy for Bond Markets Expected

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Mary Miller, director of the firm’s
Fixed Income Division, expects the
problems plaguing the credit markets
to continue into this year. But she
sees gradual improvement “as we
move troubled assets into stronger
hands and get troubled loans off the
books of financial institutions. Attention will shift from credit risk, which
has been all-consuming for the last
year and a half, to interest rate risk”
as the economy recovers.
However, the outlook for fixedincome investing remains very
uncertain. No one knows how long
or severe the U.S. recession, and
downturn in economies overseas,
will be, despite massive investments
by government authorities and
central banks.
In addition, financial institutions
globally took more than $1 billion
in write-downs of toxic assets in
2008 and the International Monetary
Fund projects the total to reach $1.4
trillion. More capital injections from
central banks and other sources will
be needed.
Ms. Miller says that the flight to
quality has driven Treasury bonds
to overvalued levels. She expects
other higher-yielding sectors to
While the global credit crisis and
depressed economy brought more
devastation to stocks than bonds in
2008, they also wreaked havoc in the
fixed-income markets, causing some
unprecedented declines.
Investment-grade corporate bonds
averaged a total return of -4.94% last
year—the worst since 1974—while
high-yield “junk” bonds suffered
a historic decline of 26.2%. That
dwarfed the prior high-yield record
drop of 6% in 1990. Meanwhile, U.S.
Treasury bonds on average provided a
total return of 13.7%.
Concerns about creditworthiness and a severe lack of liquidity
crippled credit markets in recent
months, sparking a massive flight to
quality and pushing yield spreads
for corporate, municipals, and other
bonds to record levels relative to
Treasury securities.
As a result, opportunities to earn
unusually attractive yields—even in
higher-quality bonds—are prevalent, but T. Rowe Price managers
remain concerned about the nearterm outlook and urge caution
when investing in such higher-risk
sectors as noninvestment-grade and
emerging market bonds.
2008 Bond Market Performance
Total Return by Sector as of December 31, 2008
20
15
10
13.7
8.8
8.3
Return (%)
5.7 4.4
4.3
5
-5
-2.5
-4.9
-10
-15
-20
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4.0
0.7
0
-6.0
-10.9
Three Months
YTD
-18.8
-25
-26.2
-30
U.S. Treasury*
U.S. Municipal Bond
U.S. MortgageBacked Securities
outperform Treasuries this year,
including investment-grade corporate
bonds, high-quality mortgage-backed
securities, certain asset-backed
securities, and municipal bonds.
“There is compelling valuation in
the bond market, and investors are
being much better compensated in
yields now for the risk they are taking
than they were just a few months
ago,” Ms. Miller says. “I’m optimistic
that investors will start gravitating to
higher-yielding assets in 2009.”
Brian Brennan, manager of the
firm’s U.S. Treasury bond funds,
says that investors flocking to
government bonds for safety could
actually suffer principal declines as
interest rates move higher over the
next couple of years.
“U.S. Treasuries are the gold standard for risk aversion, pushing rates
to historically low levels,” he says.
But Mr. Brennan says Treasury
investors should be cautious “unless
you feel we are going to have a
Japanese-type scenario like the
1990s, when the Bank of Japan kept
rates at very low levels for more
than a decade, and you believe that
the fiscal stimulus measures, not
just in the U.S. but globally, will
not gain any traction. You have
to be pessimistic about growth
over the next decade to be buying
longer-term Treasuries now.”
U.S. Corporate
U.S. Corporate
Investment Grade
High Yield
Global Aggregate
Emerging
ex-U.S. Dollar
Markets
*U.S. government bonds are guaranteed as to the timely payment of principal and interest.
Source: Credit Suisse, Barclays Capital, J. P. Morgan.
The U.S. Treasury is expected to
issue more than $1.5 trillion in debt
this year, but other bond markets
have been starved for capital though
demand suddenly improved at yearend, sparking a rally. The deleveraging by investors, companies, and
consumers has meant the supply of
financial assets like stocks and bonds
exceeds the demand. This illiquidity
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could reach as high as 20% over the
next couple of years—compared with
a record 16% in 1989 to 1990.
“When sentiment is as overwhelmingly negative as it is now, the market
has a tendency to overshoot on
losses,” Mark Vaselkiv, manager of
the T. Rowe Price High Yield Fund,
says. “The value of all securities has
been indiscriminately crushed, as the
market hasn’t appropriately distinguished between varying degrees of
credit quality. Many of these companies will survive.”
Mr. Vaselkiv says the economic
climate and expected default
rates, looking to 2010, are keys to
performance this year. If investors
anticipate a better economic climate
in 2010 or before, high-yield bonds
could rebound in 2009. However,
with deteriorating economic conditions and increasingly prohibitive
borrowing costs, many companies
could face strong headwinds.
But with current market yields
recently hovering around 17.5%, and
with a large majority of high-yield
issuers expected to remain viable,
investors are being well compensated
for the risks. Moreover, the market
has generated its best performance
problems in the market for Treasury
inflation-protected bonds (TIPS) and
causes stress for corporates. Deleveraging is a very powerful force so its
downward effect on price levels can’t
be ignored, and we have not really
had a fire drill on what deflation
does.”
Mr. Shackelford advises investors
to stay diversified and focus on
intermediate-term, higher-quality
bonds “which can offer good yields
in an environment where returns are
going to be tough.”
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As investors fled to Treasuries,
junk bond yield spreads widened
to record-shattering levels, pushing
toward a whopping 19 percentage
points (1900 basis points) over the
10-year Treasury yield near yearend, though that spread narrowed
to 1600 basis points in January.
In addition, more than 80% of
high-yield securities—spanning every
industry sector in that market—are
trading at distressed levels, meaning they have a high probability of
default or restructuring. This implies
that the default rate for the high-yield
market, relatively low in recent years,
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10-Year Treasury Rates and Credit Yields From December 31, 2006,
Through December 31, 2008
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and credit fears drove yields on
investment-grade corporate bonds to
9%, a record six percentage points
(600 basis points) over comparable
term Treasuries, compared with a
historically low 80 basis points in
the first quarter of 2007 before the
subprime mortgage crisis erupted.
“There are just too many cheap
assets and not enough capital to
take advantage of them,” says David
Tiberii, manager of the Corporate
Income Fund. While the yield spread
has narrowed recently, he says
investment-grade corporate securities are “fundamentally cheap” and
expects this sector to outperform
Treasury bonds over the next two
to three years. “These low Treasury
yields will get eaten up by inflation
when we return to a more normal
economic environment.”
Still, Mr. Tiberii advises caution
because “the economic cloud on the
horizon looks very bad and could
potentially push defaults or downgrades to record highs. If you are
willing to take some risk but not a lot
of risk, dip your toe into high-quality
bonds.”
Dan Shackelford, manager of the
New Income Fund, which also
invests in investment-grade debt
securities, says that with yields in
the 8% to 9% range, this sector
offers “the best opportunities I
have seen in a long time. We’re not
banking on capital appreciation, but
these yield spreads could enable you
to absorb a period of weakness and
still come out ahead.”
While Mr. Tiberii is concerned
about inflation down the road,
stemming from the massive cost of
the government’s rescue measures
and bulging deficit, Mr. Shackelford
says that in the near term the bond
market has been “bracing itself for
deflation [a sustained period of falling
prices], which is rare. That is creating
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after periods of distress, returning
44% in 1991 after the 6.4% drop the
prior year, for example.
“There is very good potential for
this market to generate significant
absolute returns once the economy
stabilizes and begins recovering,”
Mr. Vaselkiv says. “Long-term
investors may be rewarded for their
patience and courage.”
For those in a 35% tax bracket, a
30-year AAA rated municipal bond
with a recent yield of 5.8% provides
a taxable-equivalent yield of 8.9%.
Moreover, investors face significantly
less credit risk with muni bonds than
with corporate bonds.
“Munis are not immune to the
downturn,” says Hugh McGuirk, a
T. Rowe Price municipal bond
manager. “We will experience some
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credit problems, but historically the
Like investment-grade corporates,
default rate has been very low. The
the municipal bond market has sufmarket’s problems recently have been
fered from a significant supply and
more related to technical issues than
demand imbalance as hedge funds,
long-term fundamentals.”
brokerage firms, and other instituMr. McGuirk says munis offer
tional investors have pulled back
good long-term value, especially
from the market. As a result, some
if income tax rates rise in the next
states and local municipalities have
few years. He advises investors to
had difficulty issuing bonds just as
make gradual investments and focus
tax revenues are declining. This has
on intermediate-term bonds (5- to
raised credit concerns and pushed
10-year maturities) to reduce volatility.
yields to historically high levels.
“Once we find a proper equilibrium
Yields on longer-term munis (10- to between supply and demand, I think
30-year maturities), for example, have those buying munis now will be
recently been well above those of
rewarded, but it could be a rocky road
comparable maturity Treasury bonds. until we get there.”
Historically, long-term muni yields
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have averaged about 80% to 90% of
Treasury yields because muni interest Foreign bond performance was
undermined by the rapid rise of the
income is exempt from federal
U.S. dollar against foreign currencies
income tax and possibly state tax as
well, but, in December, munis yielded in the second half of 2008. T. Rowe
Price managers expect that trend
twice as much as Treasuries.
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to moderate, and note that foreign
bonds not only provide diversification for U.S. investors but also
higher-yielding opportunities for
government-issued debt.
“Foreign markets also have less
exposure to the mortgage and
housing market than in the U.S.,”
says Ian Kelson, manager of the
International Bond Fund.
Mr. Kelson says European corporate bonds are attractive, benefiting
from the European Central Bank’s
decision to cut its key lending rate,
and further cuts are expected as
economies weaken. He also sees less
currency risk in Europe with the
euro having already fallen steeply
against the dollar from its peak. And
he is finding attractive opportunities
in countries where bond prices have
declined due to selling pressure and
lack of liquidity, citing Mexico and
Hungary, two investment-grade
countries offering yields above 9%.
“By investing in several countries,
currencies, and sectors,” he says,
“U.S. investors can moderate the
risk in their portfolios and possibly
enhance their overall return.”
Bonds issued by emerging markets
offer attractive yields—10% to 12%
for sovereign issues and higher for
corporate debt—but also more risk.
This market also suffered a precipitous decline following the collapse
of Lehman Brothers last September,
the fall in commodity prices, and the
flight of capital to safer harbors.
Mike Conelius, manager of the
Emerging Markets Bond Fund, says
some markets are fundamentally
cheap and expects to see an improvement in 2009 as volatility subsides
and investors become less risk averse.
“We see this as a deep value opportunity, but one that might take two or
three years to play out, so investors
have to be patient.”
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