Key Points

Investors should prepare for a more volatile fixed income market and potentially wider credit spreads in 2015. As the Federal Reserve moves toward raising its benchmark interest rate next year, we expect the yield curve will continue to flatten. A stronger U.S. dollar, falling commodity prices and low global bond yields will likely hold down U.S. bond yields. We believe the riskier sectors of the markets are likely to underperform and higher credit quality, intermediate-term bonds will offer the most attractive risk/reward ratio in the first half of 2015.

What’s the bond market outlook for 2015? We think the end of the Fed’s bond buying programs and the prospects for rate hikes in the U.S. will bring more volatility as the U.S. economy’s course diverges from those of other developed countries.

For years, many investors feared that the end of the Fed’s bond-buying programs or quantitative easing (QE3) would result in higher interest rates. But since the Fed began tapering its bond purchases earlier this year, bond yields have fallen steeply.

This shouldn’t be a complete surprise since bond yields also fell after the last two rounds of QE ended in 2010 and 2011. Our explanation is that during times the Fed was pursuing very easy monetary policy it raised inflation expectations, sending bond yields higher. Ending QE before there were signs of inflation or very strong growth led to the opposite result: falling inflation expectations and lower rates.

Ending QE programs has led to lower Treasury yields

Note: “The 5-Year, 5-Year Forward Inflation Expectation Rate” is a measure of expected inflation (on average) over the five-year period that begins five years from today.

Source: St. Louis Federal Reserve. 5-Year, 5-Year Forward Inflation Expectation Rate (T5YIFR), average, monthly, not seasonally adjusted and 10-Year Treasury Constant Maturity Rate (GS10), percent, daily, not seasonally adjusted. Data as of December 15, 2014.

Although long-term interest rates and inflation expectations have fallen since the Fed began tapering its bond purchases, the pace of economic growth looks strong enough to warrant a return to a more normal monetary policy.

The unemployment rate has fallen from above 8% in early 2012 to 5.8%, close to the Fed’s estimate of full employment. On the inflation front, the Fed has not yet reached its 2% target, but the risk of deflation appears low.

A stronger dollar and falling commodity prices are contributing to lower inflation, but also tend to boost consumer disposable income and spending. Overall, we expect the Fed to follow through on its plan to begin raising short-term interest rates sometime in the middle  of the year if these trends continue.

Low bond yields and a flatter yield curve

The era of zero short-term interest rates appears to be coming to an end, but we expect long-term interest rates to remain low and that the dominant trend in 2015 will be a flatter yield curve. If the Fed raises short-term rates when inflation is below the 2% target, the dollar is rising, global economic growth is soft and interest rates are low in the rest of the developed world, then bond yields are likely to remain low in the U.S.

There’s some room for long-term yields to move higher, but we don’t expect a substantial increase, since U.S. yields are already well above those in the rest of the developed world.

10-year bond yields

Source: Bloomberg. Monthly data as of December 15, 2014.

U.S. Treasury yields are priced in a global market because more than half of all holders are outside the U.S. Consequently, low yields in other developed countries should mean that foreign capital continues to flow into the U.S. pushing prices up. Since prices and yields move in opposite directions, that would limit the upside potential in bond yields. For the first half of the year, a broad trading range of 2% to 2.75% appears to be a reasonable estimate for 10-year Treasury yields.

However, with tighter Fed policy on the horizon, we expect the yield curve to flatten further in 2015. The yield curve has already flattened substantially over the past six months, with the spread between 10- and two-year Treasury yields falling to 152 basis points from 260 at the start of 2014. The spread is still above the long-term average of about 90 basis points and has room to move lower in our view.

Spread between 10- and 2-year Treasuries 

Source: Bloomberg. Monthly data as of December 15, 2014.

Volatility to rise

Despite our expectation for ongoing low yields, we expect volatility to rise, reversing the trend of the past five years. By holding short-term interest rates near zero and buying bonds with an open-ended time frame, the Fed’s policies encouraged investors to move into riskier sectors of the markets in search of higher yields.

With the strong backstop of the Fed’s policies, investors didn’t demand a wide yield spread over Treasuries to hold bonds that carried greater risk, such as high yield and emerging market bonds. Yield spreads fell to very low levels and volatility declined to its lowest level in decades.

The MOVE© Index (Merrill Option Volatility Expectations Index)

Source: Bloomberg. Monthly data as of December 15, 2014.

But now that the Fed is gradually withdrawing from its very easy policies and it’s clear that we may see the first interest rate hike in years, volatility is on the rise. The early signs surfaced in the currency markets, with the dollar rising against other major currencies this summer climbing about 10% on a trade-weighted basis since then.

Demand for dollars jumped due to the contrast between the U.S.—with improving economic growth and the prospect of tighter Fed policy—and other major countries, particularly in Europe and Japan, where weak growth and easier monetary policies prevailed. Additionally, slower growth in China has weighed on many emerging market currencies, particularly those of countries that relied on exports of raw materials to China, such as Brazil.

We expect the divergence between U.S. economic growth and monetary policy and those of most other countries to continue to drive the dollar higher in 2015.

U.S. Dollar Index: 1971-present

Source: Bloomberg. Monthly data as of December 15, 2014.

A stronger dollar has many consequences. One outcome is often a drop in commodity prices and overall inflation. About 80% of the world’s globally traded goods are priced in U.S. dollars. Consequently, when the dollar rises, the nominal price of many commodities will tend to fall so that the real price to consumers remains unchanged. But falling commodity prices benefit some countries at the expense of others. Consumers of raw materials like oil and iron ore tend to benefit because the cost of imports declines, while producing countries experience a drop in revenue from exports.

Countries like Brazil and South Africa have experienced sharp declines in growth this year as the value of their exports dropped. In turn, their currencies have fallen. Brazil’s currency has declined 13.9% against the dollar since the spring and the South African rand is down by 9%. Adding pressure to commodity prices this year is the slowdown in overall global growth, particularly in China, which was a major importer of industrial goods during the past decade. The collapse in oil prices, which is partly attributable to slower global growth as well as rising supply, has caused the Russian ruble to fall to record lows, forcing the central bank to hike rates to over 17% and use foreign reserves in an effort to stabilize the currency.

Emerging market bonds: Another tough year ahead

For the bond market, the confluence of these trends—tighter Fed policy, a rising dollar and falling commodity prices—has led to sharp declines in prices for emerging market (EM) bonds.

The common theme is the slowdown in global growth over the past year, which has reduced the pace of EM exports. After rising at a double-digit pace for much of the past two decades, exports from EM countries have slowed to an annualized pace of about 4% since 2012. Slow growth and weak demand from both the developed market countries and China are the major reasons. If our expectations for a strong dollar and continued sluggish growth in Europe and Japan next year pan out, EM countries are likely to experience slowing growth and weaker currencies.

JPMorgan Emerging Market Currency Index

Source: Bloomberg. Monthly data as of December 15, 2014.

Falling EM currencies make it more expensive for borrowers to service U.S. dollar-denominated debt. About 75% of the $2.6 trillion in EM bonds outstanding are in dollars, according to an estimate from the Bank for International Settlements (BIS). And most of the $3.1 trillion in cross-border bank loans between developed counties and EM countries are denominated in dollars as well. The rout in the Russian markets reflects this concern that companies borrowing in U.S. dollars won’t be able to repay the debt. It’s a concern that applies to other EM borrowers as well.

Falling currencies can also raise inflation, which in turn may lead central banks to hike interest rates, further pressuring EM bond prices. In our view, EM bond yields don’t offer attractive enough yields to offset the risks at current levels.

High-yield bonds: Not yet high enough

In the high-yield market, falling oil prices have raised the risk of defaults. In recent years, the percentage of energy companies issuing high-yield bonds has risen due to the boom in domestic production. About 13% of the Barclays U.S. Corporate High Yield Bond Index is now made up of energy companies, triple the level of 2006. At oil prices closer to $60 per barrel than $100 per barrel, there’s a possibility that some of these speculative companies will not be able to service the debt they issued to boost production.

Prices of energy company bonds have fallen sharply, sending the option-adjusted spread of the energy subsector of the index to 786 basis points, or hundredths of a point. That compares to 528 basis points for the overall junk bond market. An option-adjusted spread is the difference between the yield on a risk-free security and a riskier security, taking into account an embedded option.

Companies needing to refinance debt may find the cost prohibitive, raising the risk that default rates among high-yield bond issuers will rise. We’re not predicting a huge increase in credit spreads on the order of the spike in 2008-2009, but higher yields would not be surprising in 2015. We still think it’s too early to jump into the high-yield market.

Spreads have increased from their 2014 lows

Note: OAS is a method used in calculating the relative value of a fixed-incomes security containing an embedded option, such as a borrower’s option to prepay a loan.

Source: Barclays U.S. Corporate High Yield Bond Index, using daily data as of December 15, 2014.

Volatility can create opportunities

We think it’s too early to try to, as some in the industry say, catch a falling knife. That means buying a fast-declining security—a risk many advise against, since falling knives have sharp edges.

Reaching into lower credit quality bonds was a successful strategy for many during times of quantitative easing, but we believe that the Fed’s shift toward more conventional monetary policy will mean that less-risky sectors of the market outperform the riskier sectors. And we believe that current yields of higher-quality bonds relative to Treasuries are reasonable since they are in line with long-term averages.

At some point, the risk/reward balance for lower credit quality bonds is likely to improve, making them more attractive. But going into 2015, we believe that Treasuries and investment grade corporate and municipal bonds will weather the expected increase in volatility.

We continue to believe that maintaining an average duration of five to 10 years for Treasuries and investment-grade corporate bonds or seven to 12 years for municipal bonds offers an attractive risk/reward ratio. The average duration can be achieved through a laddered portfolio or a barbell strategy.

Due to the steepness of the yield curve between very short-term rates and intermediate-term notes, the impact of Fed rate hikes is likely to have a large effect on shorter duration bonds. Long-term bonds are very sensitive to changes in interest rates. The wide spread between short-term and intermediate term bonds already reflects some expectation of Fed rate hikes.

Finally, we see 2015 as a transition year for the fixed income markets, but we don’t expect that it will necessarily be the beginning of a bear market in bonds. Even at low yields, bonds are a source of diversification from stocks and they still play an important role in an overall portfolio. In particular, high-credit-quality bonds can help hold down volatility, preserve capital and provide income.

I hope this enhanced your understanding of the bond market outlook for 2015. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)