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Investors Bid Up Bonds in January

Fixed-income returns were unusually strong as the ECB announced a stimulus program, uncertainty followed Greek elections, and growth slowed in China.

David Sekera: Fixed-income returns in January have been unusually strong as interest rates have declined substantially across developed markets. For example, in the U.S., the 10-year Treasury bond has declined almost 50 basis points to end January at 1.68%.

In Europe, the yield on the 10-year German bund has dropped almost 25 basis points to 0.3% at the end of January and is now currently lower than the 10-year Japanese government bond. Even yields on Italian and Spanish debt have dropped to historic lows. They're currently around 1.5%. These have traded above 7% during the sovereign debt crisis in Europe in 2011 and 2012.

There are several reasons that investors have bid up the prices of bonds. First, deflationary pressures and stagnant economic growth in Europe have led the ECB to announce that it will begin its own 18-month EUR 1.1 trillion quantitative-easing program.

Elsewhere, economic growth is slowing in other major economies. For example, China recently reported its fourth-quarter GDP growth rate decelerated to 7.3%--its slowest growth rate in years. In our view, it will continue to decelerate as real estate growth in China continues to weaken. Here, at home, economic growth slowed to 2.6% in the fourth quarter as compared with 4.6% and 5.0% in the prior two quarters.

Other potential risks that have led to the flight to safety include the election of a new government in Greece. That government has indicated that it will attempt to restructure and/or write off a significant portion of its sovereign debt. While this probably will not have much of an impact in and of itself, investors are concerned that it could set a bad precedent across the rest of the EU.

Based on the movement in underlying interest rates, the Morningstar Corporate Bond Index rose almost 2.8% in January alone. However, the average credit spread of our index actually widened 8 basis points, mainly due to weakness in the energy sector.

In the high-yield market, the BofA/Merrill Lynch Index only rose 0.7% in January, as it's not as sensitive to movements in the underlying interest rates. The average credit spread of this index widened 20 basis points to plus 526, also mainly due to the rise in default risk in the energy sector.

If oil prices remain low for the foreseeable future, defaults will likely begin to surface within the energy-services sector later this year. However, within the energy sector, credit spreads have widened appreciably and bond prices have dropped as the market has already priced in a substantially higher default-rate risk within this sector.

Bob Johnson, Morningstar's director of economic analysis, is still sticking to his forecast for real GDP growth in the U.S. to range between 2% and 2.5% this year. This amount of economic growth should be enough to keep default rates in other sectors in check for the balance of the year. As such, this should allow high-yield bonds to outperform investment-grade bonds over the remainder of the year.