Making Sense of an Increasingly Tight Market for Bonds

The first seven months of the year have been moderately generous to investors in intermediate-term bond funds. The Bloomberg Barclays U.S. Aggregate Bond Index returned a solid 2.3% from Jan. 1 through July 31, close to its gain for all of 2016.

Meanwhile, many funds that take a more adventurous approach to risk than the investment-grade index posted even better returns, thanks to gains in emerging-markets debt--peso-denominated Mexican debt was a particular standout--and junk bonds.

But recent bond strength has made for an increasingly challenging market for fixed-income investors. Treasury yields remain low on an absolute basis, while corporate bonds have enjoyed a strong rally since early 2016. The Bank of America Merrill Lynch U.S. High Yield Index offered an option-adjusted spread--which measures how much investors are paid for taking on the credit risk inherent in junk bonds--of just 3.6% as of the end of July.

That level is close to postcrisis lows, meaning that there's not much compensation for the default risk inherent in junk bonds and suggesting that, at best, high-yield bonds are likely to see relatively muted returns.

For individual investors, it's important to have realistic expectations about bond returns. With the SEC yield on

A Mostly Cautious Approach to Duration Given that the Federal Reserve has raised rates three times since last fall and seems poised to announce a scaling back of its balance sheet in September, it's not surprising that bond fund managers would be cautious on longer-term bond yields. Intermediate-term to long-term bonds have also rallied modestly year to date, although they still remain above their levels prior to the U.S. elections.

That said, even many managers with an underweighting to duration are not expecting a huge runup in rates. As of the end of the second quarter, for example, BlackRock noted that it was decreasing its underweighting to duration in

Some are even bullish on U.S. rates, although again these bets also tend to be fairly modest. The team behind

While many managers are staying relatively close to neutral in their outlooks for nominal interest rates, we're seeing more enthusiasm for Treasury Inflation-Protected Securities, which have been one of 2017's biggest underperformers to date.

Credit Looks Less Attractive After a Strong Run

From the beginning of March 2016 through July 31, 2017, the broad U.S. high-yield indexes posted 25%-plus gains. With returns of this magnitude likely in the rearview mirror, many intermediate-term bond investors with the flexibility to hold junk bonds are turning cautious on credit. The managers behind

Others maintain an overweighting to credit but have nonetheless trimmed exposures. The team at Loomis Sayles Core Plus Bond, for example, continues to favor investment-grade and less-risky junk bonds, arguing that the U.S. economy could stay in the late stages of the credit cycle for a prolonged period of time. That said, the firm reports slicing its high-yield allocation from nearly 20% in summer 2016 to 8% as of June 30.

Bullish on Securitized Securitized credit offers one of the few opportunities that many managers agree on. PIMCO, Prudential, BlackRock, and TCW MetWest all have found ample opportunity in a mix of nonagency mortgages, commercial mortgage-backed securities, and asset-backed securities, focusing primarily on senior tranches that have a first claim on assets. These firms have also found value in AAA rated slices of collateralized loan obligations (CLOs), which are backed by floating-rate bank loans. Although these structures may sound alarm bells for investors who remember the difficulties suffered by collateralized debt obligations during the financial crisis, managers note that the senior tranches of CLOs actually held up well even as bank loans suffered massive losses; newer versions of these CLOs provide more protections for senior investors.

Investors are more cautious in their approach to plain-vanilla agency mortgage-backed securities, which account for close to a third of the index. Many investors cite potential pressures on valuations as the Fed is expected to start to slow its reinvestment in mortgages. PIMCO stands out as a firm that has been more sanguine about this risk, and as a result, PIMCO Total Return has held higher allocations to agency mortgages than some peers over the past year.

A Mixed View on Emerging-Markets Debt Over the years, many intermediate-term bond managers have increasingly found opportunities in emerging-markets sovereign debt, and many added to stakes in the sector following last year's post-election sell-off. As of mid-2017, enthusiasm for emerging-markets debt varied widely across firms. BlackRock falls in the "bull" camp, with BlackRock Total Return maintaining a significant stake in emerging-markets debt as of the end of June, citing strong developed-markets growth as a powerful support for the sector. TCW MetWest, meanwhile, was relatively bearish on emerging-markets debt. The firm has raised concerns about leverage in the Chinese financial sector and notes that any problems in China are likely to quickly spread to the rest of the emerging-markets universe.