2013 Bond Market Performance: The Year in Review
Bond Market Returns: What Worked and What Didn't in 2013
The bond market received more than its share of headlines for its poor performance in 2013, as concerns that the U.S. Federal Reserve would taper its “quantitative easing” program caused investment-grade bonds to suffer their worst year since 1994. This also represented the second-worst year for investment-grade debt since 1980, the first loss since 1999, and only the third time in 34 years the asset class finished the year in the red.
Nevertheless, investors still had plenty of opportunities to make money in bonds. While the longer-term, higher-quality, and most interest-rate sensitive segments of the market lost ground, a number of areas – among them high yield bonds, senior loans, and short-term bonds – finished the year in positive territory. The result: an investor who was appropriately diversified – or who chose to access the market with individual bonds rather than bond funds – could have ridden out the year with minimal damage despite the upward spike in long-term Treasury yields.
2013 Bond Market Return Data
The 2013 returns of the various asset classes within the bond market are as follows:
Investment-grade U.S. bonds (Barclays U.S. Aggregate Bond Index): -2.02%
Short-term U.S. Treasuries (Barclays 1-3 Year U.S. Government Index): 0.37% Intermediate-term U.S. Treasuries (Barclays US Government Intermediate Index): -1.25%
Long-term U.S. Treasuries (Barclays US Government Long Index): -12.48%
TIPS (Barclays US Treasury Inflation-Linked Bond Index): -9.26%
Mortgage-backed securities (Barclays GNMA Index): -2.12%
Municipal bonds (Barclays Muni Bond Index): -2.55%
Corporate bonds (Barclays Corporate Investment Grade Index): -1.53%
Long-term corporate bonds (Barclays Corporate Long Investment Grade Index): -5.68%
High yield bonds (Credit Suisse High Yield Index): 7.53%
Senior Loans (S&P/LSTA Leveraged Loan Index): 5.29%
International government bonds (SPDR Barclays International Treasury Bond ETF): -3.59% Emerging market bonds (JP Morgan EMBI Global Diversified Index): -5.25%
The 2013 Timeline
Although 2013 is remembered as a difficult year for the bond market, the first four months of the year were relatively benign. Even as warnings about the looming downturn in bonds continued to permeate the financial press, bonds remained supported by accommodative U.S. Federal Reserve policy, strong investor demand, and the combination of low inflation and slow growth. As of April 30, investment-grade bonds were in positive territory with a gain of just under 1%.
This favorable backdrop changed abruptly in May when Fed Chairman Ben Bernanke suggested that the Fed may soon “taper” its quantitative easing policy. Adding fuel to the fire were signs of strengthening economic growth, led by the recovery in the U.S. housing market. The bond market reacted violently as investors rushed to take profits before the Fed began to withdraw its support: from May 2 to June 25, the yield on the 10-year note soared from 1.63% to 2.59% - an extraordinary move in such a short period of time.
(Keep in mind, prices and yields move in opposite directions). This yield spike led to a sharp downturn throughout the entire bond market, with even segments that typically exhibit low interest-rate sensitivity suffering substantial losses.
The bond market continued to drift lower through the summer, with the 10-year yield ultimately topping out at 2.98% on September 5. From this point, bonds staged a two-month rally that was fueled in part by the Fed surprising September 18 announcement that it would not in fact taper for the time being.
This bounce proved short-lived, however, as yields again moved higher in November and December as signs of improving growth made a near-term taper more likely. The Fed did-in-fact announce its first tapering on December 18 when it reduced the size of its quantitative easing program from $85 billion in monthly bond purchases to $75 billion. While the initial reaction in the bond market was muted, the combination of the tapering news - in conjunction with increasingly strong economic reports - drove the yield on the 10-year note over 3% by year-end.
The following table shows the range of yields for Treasury bonds of varying maturities during the course of the year.
Individuals Rotate from Bonds to Stocks
An important factor in bonds’ weak showing was the massive outflows of investor cash from bond funds and bond ETFs. A flood of new money had entered the asset class from 2010 and 2012, and it’s possible that many investors didn’t have a clear sense of the risks. Once the market began to turn south, investors engaged in as mass liquidation of bond funds.
The Investment Company Institute reports that after losing $59.8 billion in June and another $46.2 billion in July and August, bond mutual funds continued to lose assets even after the market began to stabilize: $11.6 billion in September, $15.6 billion in October, and over $19 billion in November. This indicates that investors remained extremely wary of the bond market even after the market stabilized in September and October. For the year, says TrimTabs Investment Research, bond funds experienced more than $86 billion in withdrawals.
These outflows were accompanied by a flood of $352 billion of new cash into stock funds, indicating that the 2012 predictions of a “Great Rotation” from bonds to stocks may have been on the mark.
Long-Term Bonds Hit Hard; But Short-Term Bonds Finish with Gains
As the table above indicates, long-term bonds were hit harder than their short- and intermediate-term counterparts in 2013. The primary reason for this disconnect was that investors saw tapering as being a threat only to the long end of the yield curve since short-term bonds are more closely pinned to the Fed’s interest-rate policy. Since the Fed wasn't expected to raise rates until 2015 at the earliest, short-term bonds were sheltered from the turmoil that hit the bond market in the past year. This is reflected in the performance of three Vanguard ETFs that invest in bonds of varying maturities:
|Vanguard Short-Term Bond ETF||BSV||0.15%|
|Vanguard Intermediate-Term Bond ETF||BIV||-3.59%|
|Vanguard Long-Term Bond ETF||BLV||-8.95%|
An important result of long-term bonds’ underperformance is that the yield curve steepened during the year. In other words, the yields on longer-term bonds rose faster than the yield on shorter-term bonds, increasing the yield gap between the two segments. While the difference between the 2- and 10-year Treasury yields stood at 1.51 percentage points on December 31, 2012, the gap had increased to 2.68 percentage points at the end of 2013.
High Yield Bonds and Senior Loans Dominate
While bonds with the highest sensitivity to interest-rate movements performed poorly in 2013, the same can’t be said for those whose main driver is credit risk. High yield bonds delivered outstanding relative performance on the year, thanks to the combination of stronger economic growth, the improving health of high-yield companies’ balance sheets, a low default rate, and rising stock prices.
In a reflection of investors’ appetite for risk, lower-rated high-yield bonds outperformed higher rated securities during the year. Also, high yield bonds’ lower sensitivity to interest rate risk made them an attractive option at a time of turbulence in the Treasury market.
The strength in high yield was reflected in its falling yield spread – or yield advantage – over Treasuries during the course of the year. The BofA Merrill Lynch US High Yield Master II Index spread stood at 4.00 percentage points (basis points) over Treasuries on December 31, compared with 5.34 on December 31, 2012. The low for the year was 3.96, recorded on December 26 and 27.
Senior loans, or loans that banks make to corporations and then package and sell to investors, also performed very well. Investors were attracted to this growing asset class due to its favorable yields and floating rates (seen a plus at a time in which yields are rising). Senior loans also benefited from substantial inflows to funds and ETFs that invest in the space, which represents a distinct contrast from most segments of the market.
Treasuries, Investment Grade Corporates, and TIPS Lag
On the other end of the spectrum, bonds that are most sensitive to prevailing rate movements took it on the chin in 2013. Yields on U.S. Treasuries spiked higher as prices fell, with the worst losses occurring in bonds with the longest maturities. This downturn fed through to Treasury Inflation Protected Securities, or TIPS, which were hit not just by rising rates but also the declining investor demand for inflation protection.
In contrast, mortgage-backed securities (MBS) – a large component in many domestic bond index funds – lost ground in the year but finished ahead of government bonds. MBS were helped by continued Fed asset purchases, as $45 billion of the $85 billion monthly bond-buying program targets mortgage-backed securities.
Corporate bonds also lost ground in 2013. The downturn driven entirely by the increase in Treasury yields, based on the fact that corporates’ yield spread over Treasuries actually declined in 2013. The BofA Merrill Lynch US Corporate Master Index began the year with a yield advantage of 1.54 percentage points, and it stood at 1.28 on December 31. The spread was relatively stable through the year, with a high of 1.72, hit on June 24, while the 1.28 level marked the low. The decline in the yield spread – as well as its lack of volatility – helps illustrate investors’ confidence in the health of Corporate America, as reflected in steady earnings growth and robust balance sheets.
The underlying strength in the market was also demonstrated by the massive amount of new bond issuance by corporations that were seeking to take advantage of the low-rate environment. The level of demand was illustrated by Verizon’s ability to issue $49 billion in new debt during the third quarter and still have the deal oversubscribed (meaning that there was more demand than supply despite the size of the deal). According to the Wall St. Journal, U.S. investment-grade companies sold $1.111 trillion of bonds during 2013, a new record.
Nevertheless, these positive factors weren’t enough to offset the impact of rising Treasury yields given corporates' high correlation with government bonds.
The downturn in Treasuries, TIPS, MBS, and corporates helps illustrate an important point: “high quality” doesn’t necessarily mean “safe” once yields begin to rise.
Municipals Pressured By Adverse Headlines and Fund Outflows
The year also proved to be difficult for those invested in municipal bonds. Investment-grade municipal bonds underperformed their taxable counterparts in 2013, and high yield munis fell well short of the returns of high-yield corporate bonds. As was the case in the rest of the bond market, longer-maturity bonds suffered the worst performance.
The primary factor weighing on municipal bonds was, of course, the sharp spike in government bond yields that occurred during the spring and summer. Beyond this, however, munis faced the additional headwinds caused by Detroit’s bankruptcy, Puerto Rico’s fiscal problems, and the uncertainty related to outlook for federal spending. Together, these considerations led to extraordinary outflows for municipal bond funds. The Investment Company Institute calculates that municipal bond funds shed $82 billion in assets just from June to October, a stunning reversal from the nearly $50 billion that poured into such funds in 2012.
This compelled fund managers to sell their holdings to meet redemptions, exacerbating the downturn.
Despite these trends, the underlying fundamentals of the asset class actually remain sound, with increasing tax receipts for state and local governments, low defaults, and yields that are at historically high levels in relation to taxable bonds.
International Markets Flat, But Currencies Weigh
Investors gained little from diversifying their bond portfolios overseas in 2013. The international bond markets, as a group, finished the year flat as strong gains in smaller European economies such as Spain and Italy were offset by weakness in larger markets such as Canada and the United Kingdom.
U.S.-based investors nonetheless finished the year in the red due to the weakness in foreign currencies against the U.S. dollar. While the non-U.S. portion of the JP Morgan Global Government Bond Index returned 1.39% in local currency terms during 2013, it fell 5.20% when measured in U.S. dollars (through December 27). The largest return gaps between local-currency and dollar-denominated returns occurred in Japan, Australia, and Canada, all of which saw their currencies fall against the dollar. As a result, unhedged foreign government bond portfolios generally finished the year in negative territory.
Emerging Markets Face Multiple Headwinds
Emerging market bonds also closed 2013 in the red, but virtually all of the downturn occurred in the May-June selloff.
During this time, investors exited the asset class in droves as rising Treasury yields caused investors to lose their appetite for risk. The emerging debt markets were also hurt by slower-than-expected growth in key markets such as India, Brazil, and Russia, as well as periodic concerns about a possible “hard landing” in China’s economy. Further, rising inflation pressures caused a number of emerging-market central banks to begin raising rates – a reversal from the long cycle of rate cuts that occurred from 2008-2012.
Taken together, these factors caused emerging market bonds to finish with their worst year since the 2008 financial crisis.
The hardest-hit segment of the asset class was local currency debt (as opposed to those denominated in U.S. dollars). Capital flight contributed to weakness in the value of many emerging currencies since investors who sell bonds in a foreign country must also sell the currency to do so. As a result, local-currency bonds were pressured in two ways: first, by the falling value of the bonds themselves, and second, by the falling value of the currencies. During 2013 the Wisdom Tree Emerging Markets Local Debt Fund (ELD) returned -10.76%, well below the -7.79% return of EMB.
On the other side of the equation, emerging market corporate bonds held up better on a relative basis, as reflected in the -3.24% return of the WisdomTree Emerging Markets Corporate Bond Fund (EMCB). Emerging corporates feature offer higher yields and lower interest-rate sensitivity than most areas of the bond market, and they also tend to be relatively insulated from many of the concerns that dogged emerging market government debt, such as rising inflation and higher trade deficits. This market segment won’t be immune to shifts in investors’ risk appetites, but in 2013 it demonstrated its above-average ability to withstand rising Treasury yields.
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