Thoughts on 2018's bond market

Over 80 percent of forecasts for 2017 were for interest rates to rise. Most were recommending shorter maturities. Our work, based on historical data, suggested that 2017 would be a good year for bonds (and perhaps a great year). Our analysis concluded that when you have carnage in the bond market caused by a rapid rise in interest rates that we saw in the second half of 2016, the next one to two years tends to produce attractive bond market returns. Wall Street forecasters were correct that short-term interest rates would rise because of increases in short-term rates by the Federal Reserve but very wrong in advising clients to own short maturities. Maturities in the 2-9 year range experienced horrible total returns due to the rise in short-term interest rates. However, bonds with 20-30 year maturities experienced exceptionally good returns doubling their coupon returns caused by a downward shift in interest rates for these maturities. Thus, a barbell strategy drastically outperformed a laddering strategy in 2017. On average, our clients' returns should come in at 1-1/2 times coupon returns for 2017, making it a very good year. In looking ahead into 2018, we continue to expect the yield curve to flatten - led by at least two rate hikes by the Fed. With this expectation, we believe that a barbelled portfolio should continue to work best until we get through rate increases by the Fed. Historically, the second 12 months after severe bond market carnage (e.g., the second half of 2016) has been very good for the bond market in producing positive bond market returns. Even though the second year has been slightly better than the first year, results have been more mixed - but all have been positive. Also, the long end of the bond market tends to perform well during the later stages of Federal Reserve rate hikes. The biggest surprise of 2017 is the 10% to 12% decline in the U.S. dollar compared with our major trading partners. Investors in these other countries must not have owned many long-term U.S. bonds. I don't expect the U.S. dollar to continue to lose value, especially in light of the recently passed tax reform package. Additionally, U.S. investors feel our interest rates are low compared to the past, but in relationship to the rest of the world, they are actually very high. For example, interest rates on our 10-year sovereign debt are much higher than any other country in Europe other than Greece. Again, unlike most Wall Street forecasts, I expect another good year for the U.S. bond markets based on historical data, the fact that we're late in Fed's tightening cycle, our high relative interest rates, and prospects for the U.S. dollar to strengthen. To get the most out of your bond portfolio, I believe you should be barbelled as the yield curve continues to flatten. Once the Fed finishes tightening, intermediate term bonds should then be overweighted in bond portfolios. Expect 2018 to be another good year for bond investors. ----- George W. Karpus is chief investment strategist and chairman of the board of Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully's Trail, Pittsford, NY 14534, (585) 586-4680. Published: Fri, Jan 12, 2018