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Last week, we got more evidence that the economy appears to be shaking off its weather-related problems. New economic reports, including new manufacturing numbers and Friday’s better-than-expected U.S. non-farm payroll report, confirmed that the economy has strengthened since February.

However, despite the better data, interest rates remain range bound, i.e. stuck within a low and narrow range. Why the disconnect? One factor keeping rates low is a lack of overall wage growth and overall inflationary pressure. As I write in my new weekly commentary, while job creation is accelerating, wage growth is not. And without faster wage growth, inflation is staying low, allowing the Fed to take its time in rising rates.

This phenomenon was reinforced by Friday’s jobs report. Despite the biggest surge in jobs year-to-date, hourly wages were flat and are now up less than 2% year over year. For now, the lack of wage pressure is giving the Federal Reserve (Fed) time and keeping rates range bound. In addition, as I’ve discussed in the past, other factors are at work as well. A lack of supply of quality paper, demand for long-dated bonds by pension funds, and demographics are all adding to the downward pressure on interest rates.

With rates stuck at historically low levels, and likely to remain that way at least into early 2015, investors are bidding up bonds and driving spreads lower, continuing to search for yield. However, as I’ve mentioned before, the search for yield is starting to look excessive.

For instance, in Europe, Spanish bond yields continue to fall, with the yield on 10-year sovereign debt breaking below 3% last week. Canada, one of the few AAA rated sovereigns left, sold 50-year bonds at less than 3%. And in the United States, $12 billion of new bonds issued by Apple Inc. garnered $40 billion in offers.

In my opinion, investors may be stretching too far for income for yield and ignoring risk. While there are few bargains within fixed income, I continue to like those parts of the market that offer some relative value, including tax-exempt bonds and mortgage-backed securities. In addition, for more yield hungry investors, I’d advocate some exposure to U.S. high yield. You can read more about my fixed income outlooks in my latest Investment Directions monthly market commentary.

Sources: Bloomberg, BlackRock Research

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.

 

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable.

Mortgage-backed securities (“MBS”) and commercial mortgage-backed securities (“CMBS”)  are subject to prepayment and extension risk and therefore react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly and significantly reduce the value of certain mortgage-backed securities.

 

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