Matt Tucker: 3 Bond Strategies for the New Year

In my last post, I took a look back at the fixed income strategies that I proposed at the beginning of 2013 to see how my ideas fared.  In some ways, the year shaped up much the way I expected with modest economic growth and the Fed maintaining their quantitative easing program.  However, while the Fed’s actions kept short term interest rates low, the Fed’s general tone and guidance made investors nervous, causing longer term rates to rise – and bond portfolios to suffer.

These events were a great illustration of how forecasting the market environment is not just about data analysis, but also very much about investor sentiment.  With the Fed continuing to be active with QE, what they say is in some ways as important as what they do.  This should continue to be a significant theme in the New Year.

So what’s on tap for bond markets in 2014?  Like last year, it will likely be all about slow growth and policy-driven markets.  The Fed has announced that it will begin to taper its bond-buying program in January, which should continue to drive up the rates on 5+ year bonds.  Meanwhile, the Fed Funds rate will probably remain zero for the year, anchoring short term fixed income yields.  Finally, inflation should remain close to historic lows, and volatility will once again be front and center.

With these considerations in mind, I’ve once again gathered my three current favorite strategies for bond investors to consider – just in time for 2014:

1. Continue to shorten duration.  The 2013 bond strategy of the year was, without a doubt, duration rotation.  Essentially, investors anticipating a rise in rates responded by shortening the duration of their fixed income portfolios.  Even though the Fed has begun to taper, we would expect this trend to continue for a while.  But investors should keep in mind that Treasury rates are approaching fair value given current levels of growth and inflation.  Unless one of these two factors spikes in 2014, the rate increases we do see are likely to be more modest than what we saw in 2013.  And the trend towards higher interest rates may slow down significantly in the second half of 2014 when tapering brings the QE program to a close. Potential iShares solution: iShares Core Short-Term Bond ETF (ISTB)
2. Step out of cash.  With short-term interest rates near zero, investors are receiving a negative real return on cash investments after inflation is factored in.  While no investment is as safe as cash, short duration bonds offer relatively low interest rate risk with the opportunity for a higher yield than cash.  This is likely why we’ve seen many investors this year use short duration ETFs as a way to toe-dip back into the market.  Potential iShares solution: iShares Short Maturity Bond ETF (NEAR)
3. Consider munis – but proceed with caution.  In a market where it’s hard to find yield, munis should continue to be attractive on a tax-adjusted basis.  For example, the iShares National AMT-Free Muni Bond ETF (MUB). However, munis are extremely rate-sensitive so will react to every bump in the road as rates continue to climb – securities on the shorter duration end of the spectrum should have an easier time. We also will likely see more volatility on the back of further news on Puerto Rico and other potential credit issues, muni bond investors need to expect this.  Potential iShares Solution: iShares Short-Term National AMT-Free Muni Bond ETF (SUB)

No matter what your outlook is, it’s always important to consider what role bonds play in your portfolio before choosing a fixed income strategy.  Are you seeking yield? Do you want more portfolio stability?  How about diversification?  If you continue to keep your objectives in mind, your bond investments should serve you well throughout 2014 and beyond.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.  You can find more of his posts here.