With nearly two months of the year behind us, we thought now would be a good time to see how the fixed-income market is faring in 2014 and assess our outlook. We asked our investment team five questions to help capture our view on the market today.

Are we still concerned about rising interest rates?

Yes. Looking at the big picture, we are still in the early stages of the Federal Reserve’s (the Fed) exit process. Tapering, or the reduction in asset purchases by the central bank, will likely continue at a steady pace over the course of the year, unless the economy experiences a dramatic shift from its current path.

Tapering was the story of 2013 and largely explains the significant rise in intermediate- and long-term rates last summer. The next big move in rates may be triggered by concerns about possible future Fed rate hikes. We aren’t there, yet — and a move by the Fed before 2015 seems highly unlikely — but similar to the tapering trade, expect bonds to re-price well in advance of any Fed action. An important difference in the next big move in rates is that it will likely take place in shorter maturities rather than long maturities. In bond jargon, we expect the yield curve to flatten.

Has the outlook for high quality bonds improved?

Modestly. 2013 was the second worst calendar year on record for the Barclays Aggregate Index with a negative return of 2.9% and only the third negative total return for the Index (data going back to 1976). The other negative return years — 1994 and 1999 — were followed by healthy double digit gains.

Why not a similar bounce in 2014? First, the starting point (yield) is much lower today than at the beginning of 1995 and 2000, even after last year’s rate move. Also, the Fed is just starting the exit process by turning down/off quantitative easing and the market hasn’t priced in any significant future rate hikes, yet. Finally, risk premiums, or the extra yield spread that investors command for non-Treasury sectors, are at or near the tight end of recent range. In other words, mortgage and investment-grade corporate risk premiums may not be able to tighten enough to offset the effect of rising rates. High-quality bonds may struggle to generate coupon-like returns, which is better than last year but nothing to brag about.

Do we prefer high-yield bonds or bank loans?

High-yield bonds. High-yield bonds and bank loans were the only two winning sectors in fixed income in 2013 with returns of 7% and 5%, respectively. We are comfortable holding our current positions in high yield and bank loans, but not adding. Corporate fundamentals remain strong, which is supportive of both asset classes. Some credit metrics have deteriorated modestly — leverage and shareholder activism on the rise — but defaults remain very low by historical standards at less than 2%. Valuations are pricing in low default rates to persist at or near current levels.

The reason we pick high-yield bonds over loans may seem counter intuitive, but it is mostly about technicals. Both sectors experienced strong inflows in 2013, but the pace of flows into bank loans has been extreme. Given our own rate concerns, we sympathize with investors who are attracted to loans based on decent fundamentals and no interest rate risk, but this appears fully reflected in current prices. We doubt these two sectors will perform as well as they did in 2013, but we think they will fare better than most other fixed income choices in 2014.

Will emerging market bonds finish first or last?

First. In 2012, emerging market (EM) bonds generated the highest total return in fixed income (18%). Last year, EM bond returns ranked near the bottom, losing more than 4%. Recent poor performance can be explained as payback (reversal of strong inflows when the sector was in favor), concerns about tapering, China slowing and deteriorating growth prospects more broadly in EM countries. Countries in the EM debt market that suffered the most last year were those that ran large current account deficits and faced potential funding challenges when the Fed tapered (i.e., the so-called “Fragile Five” countries of India, Indonesia, Turkey, Brazil and South Africa).

These risks warrant caution for sure, but the broad sell-off may be creating opportunities in countries that make prudent policy decisions regarding fiscal policy, interest rate management, etc. Moreover, the next big theme for the EM debt market may be less about current account deficits and more about overall level of growth. To that end, while some countries continue to disappoint in this area, we think emerging markets will ultimately benefit from the synchronized uptick in growth in global developed markets. To qualify our answer to the question, we have a fairly high conviction that EM bonds will perform well in 2014, and a very high conviction the sector will perform well over the next three years.

Same question for municipal bonds?

Maybe not first, but should win a medal. Municipal bonds suffered with most other high-quality fixed-income sectors in 2013. The asset class tends to have longer durations so rising rates can be challenging. Munis also suffered from negative headlines (such as Detroit, Puerto Rico) and persistent outflows. But the underperformance of the sector appeared excessive to us. Any fixed income asset class that has duration warrants some caution, but intermediate- and high-yield muni funds may be attractive alternatives with less rate sensitivity. The headlines are not trivial — especially Puerto Rico — but we do not think the issues are widespread as most state and local finances appear on the upswing. Finally, we would agree with the prevailing view that tax rates are not moving lower anytime soon and the tax advantage of municipal bonds is compelling.

Disclosure

The views expressed are as of 2/24/14, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.

This material may contain certain statements that may be deemed forward-looking. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable.

Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.

Securities products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC.

© 2014 Columbia Management Investment Advisers, LLC. All rights reserved.

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