Expected interest rate hikes by the Federal Reserve have produced volatile fixed-income markets that are extremely challenging for many investors. But in spite of the uncertainties, financial advisors know that bonds add needed diversity to portfolios and are less risky than stock over the long term. They deliver income on a schedule to investors who need cash flow in retirement.

In the following pages, bond portfolio managers offer their outlooks in 10 commentaries that provide valuable insight on what financial advisors should consider when deciding how to allocate clients’ money to this essential asset class.

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Michael J. Collins
Senior Investment Officer and Senior Portfolio Manager for Multi-Sector
Fixed Income Strategies

Prudential Fixed Income 

Conditions May Favor Absolute Return

While perhaps counterintuitive, the economic recovery may have once again created opportunities in the bond market. After a three decade bull market in interest rates, the vast majority of appreciation from declining rates in developed countries is largely behind us. As such, some investors are looking for strategies that can provide higher yields than cash and also help hedge against rising rates.

An “absolute return” fixed-income strategy may meet both of these objectives. Absolute return solutions come in many flavors with different parameters. We believe a well-diversified strategy that actively manages duration, within a modest band relative to a near zero duration cash benchmark, represents the best approach to keeping the alpha associated with fixed-income security selection while limiting the structural interest rate beta. By comparison, portfolios with wider duration bands (e.g., up to five years) may result in a return series that is inconsistent with an investor’s objective since the portfolio may drift into an intermediate or long duration “style box”, possibly at an inopportune time.

In our opinion, actively managing a diversified portfolio across sectors, security types, rates, and currencies in both developed and emerging countries provides the strongest base to consistently generate alpha, respond to changing market conditions, limit idiosyncratic risk, and manage risk.

Another potential benefit of a diversified, duration-constrained absolute return strategy is that it tends to have a low correlation to traditional fixed-income portfolios. During periods of rising government bond yields, an absolute return portfolio with a near zero duration has the potential to post positive returns.
Although the bull market in developed country government bonds is largely behind us, we believe fixed income could still provide plenty of alpha opportunities for investors.

See our corporate profile and important disclosure information on page 113.

Visit prudentialmutualfunds.com/manage-fixed-income-risks for more information.

David B. Mazza
Head of ETF Investment
Strategy, Americas,
State Street Global Advisors

Adapted from After The Dust Settles: Fixed Income in a Rising Rate Environment

With abnormally low yields over the last few years, investors have been on high alert to the potential impact that an unpleasant end to a 30-plus year bull-run in bonds could have on their portfolios. With U.S. 10-Year Treasury yields rising sharply since the end of April, many investors are now feeling the pain.

However, fixed income can and should remain core to investment portfolios due to its potential for income generation, diversification and capital preservation. Fortunately, there are opportunities available for savvy investors to create portfolios regardless of how far and fast rates may rise over the rest of the year.

With 10-year TIPS moving into positive territory, investors appear to be pricing in Fed tightening or at least tapering sooner than many expected. In fact, yields could move up if economic growth surprises to the upside or the market continues pricing in Fed policy changes earlier than expected. Many are looking back to previous Fed tightening signals for clues and courses of action. With 1994 and 2004 potentially providing weak guidance due to the extent of extraordinary monetary policy today, investors should look beyond the core to build portfolios that behave less like return-free risk. In doing so, investors can also move beyond certain well-trodden segments that may be crowded and no longer offer their historical value propositions. We believe unique credit exposures across multiple sectors are potentially an attractive solution today and may allow for the development of more resilient and adaptive fixed-income portfolios in a rising rate environment. Investors should consult their financial advisor to determine the desired portfolio allocation to meet their needs.
See our corporate profile and important disclosure information on page 113.

Visit ssga.com for more information.

Tad Rivelle
Chief Investment Officer, Fixed Income
TCW MetWest

Bernanke’s Taper Tinkering
For the past five years, the Fed has cast an exceedingly long shadow over the capital markets. Yet, after multiple rounds of stimulus, the U.S. economy has continued to disappoint on the metrics that matter most: job creation and economic growth.

Financial repressive policies were launched in 2008 in response to the systemic risks that were posed by the calamitous decline in asset prices. Judged by the level of financial stabilization that was achieved, QE1 can be judged “safe and effective” in the treatment of systemic risk. Encouraged, the Fed initiated QE2 in 2010 to ease policy at the “zero bound” and buy deflation insurance. The Fed recognized that by lifting market expectations of inflation, it could effectuate lower real rates. QE2 appeared to have some success on this front. In 2012, QE infinity was expected to solve for “full employment.” The Fed was looking to take a weak recovery and make it strong by embarking on an expansion of its balance sheet.

Investors are increasingly aware that monetary policy is not a panacea and that QE3 is not meaningfully lifting the pace of hiring. Further, the Fed’s extraordinary policy regime seems out of place five years after the financial crisis. Zero rates and QE have begotten distorted decision-making that has taken the form of an excess of capital flows into real-estate, leveraged finance, the emerging markets, and stocks. Asset prices have become at least moderately decoupled from fundamentals as evidenced by such dynamics as rapidly rising real-estate prices unsupported by stagnant wage and job growth.

Consequently, many have a deeper appreciation that QE3 may both lack efficacy in the treatment of a weak recovery and may not be safe given the side effects that are being manifested. For these reasons, we believe that the end of QE3 is nigh, and that financially repressive policies may be generally tapered over the course of 2014.

See our corporate profile on page 113.

Visit tcw.com for more information.

Dirk Hofschire
Senior Vice President,
Asset Allocation Research Team
Fidelity Investments

Outlook For Bonds In A Challenging Yield Environment

The current environment is tremendously challenging for fixed-income investors. The same accommodative monetary policy in place to quell deflationary trends and promote spending, investment, and job growth, has contributed to rising bond valuations and slim yield spreads. As advisors look to the bond sector for income, diversification, and capital preservation, they are concerned about the outlook for interest rates in this low-yield environment.

Key themes to consider:
• With U.S. economic growth likely to remain slow and declining demographic growth patterns globally, there is little risk of an aggressive Fed tightening over the next couple of years.
• While advisors need to help investors adjust their return expectations developed during years of strong returns for high-quality fixed-income assets, they should also make sure they continue to recognize the role this sector can play when seeking stability and diversification.
• Even in a low rate environment, history suggests high-quality bonds exhibit lower performance volatility than equities and other riskier asset classes, as well as provide important diversification benefits.
• The attributes of high-quality bonds continue to make them an important anchor within a fixed-income asset allocation.

Within an overall asset allocation, an actively managed portfolio composed of multiple fixed-income sectors can help investors meet their investment objectives—notwithstanding the interest rate environment. Active management can address the intricacies of the fixed-income market while providing bond exposures aligned with investor objectives. This approach can provide the tactical adeptness necessary as markets evolve and performance leadership changes among diverse sectors.

See our corporate profile on page 111.

Visit advisor.fidelity.com for more information.