After enduring their first negative year in more than a decade, US bond investors face further challenges in 2014 as the Federal Reserve starts retreating from its era of easy money.

The Barclays US Aggregate bond index, dominated by Treasury, mortgage and corporate securities and the leading benchmark followed by institutional money, is set to record its first negative year of total returns since 1999, a year when, as in 2013, equities posted a strong performance.

One glimmer of hope for bond investors is that the full extent of bond losses from this summer’s turmoil of sharply rising yields, which move inversely to prices, has been pared in recent months. This reflects investors becoming more comfortable with the idea of the Federal Reserve winding down its quantitative easing policy over the next year in a measured fashion, and not tightening monetary conditions until late 2015.

From a low of 1.60 per cent in May the 10-year Treasury yield is ending the year shy of 3 per cent, and under a slow taper and a stronger economy, this benchmark is seen rising further in 2014.

David Ader, strategist at CRT Capital, says the Fed will remain a hefty buyer during much of 2014 after the taper starts, and that 10-year yields are likely to trade near the nominal growth rate of the economy, around 3.5 per cent.

“Consider that inflation is likely to remain on the low side and that even with tapering the Fed will likely be buying something for most, if not all of 2014, then the move to 3.5 per cent will be a very gradual one indeed,” says Mr Ader.

Still, there is a concern that yields may drift higher as the Fed steps back from being the biggest buyer in the market.

“The challenge we have is that the Fed’s buying of Treasuries under QE will decline by more than half next year as it tapers. If the Fed is not buying then someone else has to step up,” says Alex Roever, managing director at JPMorgan. The bank estimates the Fed will buy $235bn of Treasuries in 2014, down from $540bn of purchases during 2013.

That says Mr Roever should result in 10-year Treasury yields rising towards 3.25 per cent next year as the Fed tapers QE, ultimately reaching 3.65 per cent towards the end of 2014.

For the broader US bond market, much depends on the direction of US Treasury yields, which serve as a benchmark for lower rated corporate debt as the Fed reduces the supportive role played by QE.

The best case scenario for investors seeking fixed returns in 2014 is that a gentle rise in Treasury yields as the Fed tapers its bond buying does not ripple into other areas of the bond market, and facilitates modest gains from investment grade and junk-rated debt.

“We expect 2014 can be a year of modest capital appreciation by credit, with neither investment grade or junk-rated bonds delivering their long-term historical return,” says Edward Marrinan, head of credit strategy at RBS Securities. “A relatively modest rise in Treasury yields will help investment grade stay positive.”

In the likely challenging environment of investors and markets having to negotiate the Fed’s exit from QE, Mr Marrinan says expected investment grade total returns are in the 1 per cent to 2 per cent range, better than 2013’s loss of 1.8 per cent, but still well inside the market’s average gain of 7.5 per cent.

For junk bonds, expected total returns are forecast to be in the region of 5 per cent to 6 per cent, lagging behind the long-term average of 9.9 per cent since 1991, says Mr Marrinan.

All bets are off should volatility in the bond market return to the peaks seen this summer, and investors to doubt whether the Fed can keep short-term rates contained via its policy of communicating future rate hikes some way into the future, known as forward guidance.

“The Fed will likely discover that forward guidance is not quite as powerful as they think once QE is taken away,” says Peter Fisher, senior managing director at BlackRock.

The big worry for bond investors will be any acceleration in the economy that fans expectations of a rate hike by the end of 2014, similar to what investors priced in earlier this summer.

“There is a risk that the market may believe the Fed needs to tighten more aggressively than what is currently anticipated,” says Mr Roever. “If the economy performs better, then two-year yields will go up more as we enter the second half of the year.”

Rajiv Setia, head of US rates research at Barclays, adds: “The market is being very patient with the Fed and its forward guidance is holding things together, but it’s an uneasy equilibrium. To the extent there is a pickup in the economy, the market will not be patient forever.”

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