Market Commentary
Bond market outlook:
Interest rates a determining factor
Lisa Black, Head of Global Public Fixed Income Markets
Since the start of the financial crisis in 2008, the United States and other nations have promoted
policies intended to push interest rates lower to stimulate their economies. In turn, lower interest
rates have driven bond prices higher and generated strong returns for some investments in fixed
income instruments. We believe that investors with exposure to bonds of any kind need to stay
focused on economic developments, such as interest rates, and understand how these developments can impact their portfolios.
Winners and losers
The principal segment of the bond market benefiting from lower interest rates has been mediumand long-term U.S. Treasuries and inflation-linked bonds. In addition, highly rated corporate bonds
have held their own in this low interest-rate environment.
On the flip side, short-term fixed-income investments — often purchased by money market funds
— were negatively impacted by lower interest rates. In addition, high-yield corporate bonds and
emerging market bonds underperformed U.S. Treasuries until the fourth quarter of 2011. While the
short-term interest rate environment is unlikely to change this year, we believe that other factors,
such as the more encouraging U.S. economic outlook, will benefit high-yield corporate and emerging
market bonds this year.
Flight to safety
Sluggish economic growth in the U.S., coupled with Europe’s sovereign debt crisis, has driven many
investors to seek out the safety, stability and steady returns offered by U.S. Treasuries and, to a
lesser extent, highly rated corporate bonds. These strong elements of the bond market are illustrated by the performance of the Barclays U.S. Aggregate bond index, which includes a mix of government and corporate bonds, since the onset of the global financial crisis. The index rose 7.84% last
year — its best performance since 2002 — and also turned in solid returns in 2010 (6.54%) and
2009 (5.93%), when interest rates were low.
But consider these factors
In 2012, a number of interrelated factors will influence the direction of the bond market. One is the
Federal Reserve’s recent announcement that it will keep short-term interest rates at “exceptionally
low levels” at least through late 2014. By doing so, the Fed hopes to spur borrowing and stimulate
the economy. In the meantime, however, it all but ensures that returns in money market funds and
short-term bonds will remain at, or near, zero. Given the continuing slow recovery from the Great
Recession, including high unemployment and a very weak housing market, we believe that these
conditions are unlikely to change anytime soon.
Another key factor influencing the performance of the bond market in 2012 is inflation. Last year,
fears of inflation, coupled with the Federal Reserve’s so-called “Operation Twist” initiative (buying
long-term bonds, to help reduce long-term interest rates) helped trigger large gains among inflationlinked bonds. Accordingly, the Barclays U.S. Government Inflation-Linked Bond Index rose 13.56% in
2011. The Fed’s recent announcement of a formal target for the U.S. inflation rate of 2% reflects its
belief that inflation is not a major concern and the economy is not at risk of overheating. As a
result, we anticipate smaller gains among inflation-linked bonds. In contrast, nominal bonds are
likely to be bolstered by lower inflation expectations, since unexpected inflation won’t eat into real
bond returns. (Nominal Treasury securities provide “before-inflation” returns.)
Most important for the bond market is the direction of the U.S. economy and the sovereign debt
crisis in Europe. Continued improvement in the U.S. economic growth numbers will put modest
upward pressure on longer-term interest rates, as investors exhibit greater tolerance for risk. The
hunt for yield was underway in the fourth quarter last year, with a high-yield bond index generating
a 6.46% return — higher than any other fixed income class. Conversely, the turbulence in Europe
curbed some risk-taking, which depressed returns among eurozone government bonds, which fell
3.73% in the fourth quarter. While these bonds are attractively priced, the continued uncertainty in
Europe could continue to put a damper on performance.
Bottom line for investors
For investors, a strengthening U.S. economy could translate to strong performance among bonds
linked to sectors benefiting from higher consumer demand for energy and other commodities.
Energy and commodity producers experienced a roller coaster ride in 2011, but rising demand
and supply concerns should bolster energy prices and investors’ perceptions of the ability of these
producers to pay back debt. We expect the high-yield bond market to build on its fourth quarter
performance as investors become more confident about the economic outlook. More generally,
corporate bonds tend to perform well in periods of stronger economic growth, as there is more
tolerance for risk and the higher returns that compensate for that risk.
This material is for informational purposes only and should not be regarded as investment advice or a recommendation or an offer to buy or sell
any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.
Please note that fixed income investing involves risk.
Past performance does not guarantee future results.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group
of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC and
Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc. is a registered investment adviser and
wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA).
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