Prudential’s first quarter outlook predicts that fixed income is poised for an upside surprise despite the stock market’s downturn.

"The areas of most interest are higher quality structured product sectors and AA and AAA have the best risk reward while offering little credit risk,” said Robert Tipp, chief investment strategist with Prudential Fixed Income and a manager on the Prudential Total Return Bond Fund (PDBAX), who hosted a recent outlook call focused on fixed income.

The new year is off to a rocky start with slower growth in China, falling oil prices, geopolitical instability and the threat of bankruptcies in junk bonds, all of which contribute to prolonging the volatility that marked 2015.

“While we do not believe the stock market will end the year with a significant decline, we do think that volatility will be a recurring theme in 2016 marked by several intermittent starts and stops in the stock market,” said Bill Walsh, CEO of Hennion & Walsh

Tipp noted that pressure from hedge funds’ forced-selling is pushing spreads out to levels that create buying opportunities for funds with cash to put to work. 


“The impression we have is that some hedge funds have been experiencing withdrawals because of a difficult performance environment,” Tipp said. “Buying as spreads widen is an area we’ve had exposure to and that we are actively looking at.” 

Investment grade municipal bonds and preferred securities are among the asset classes that have traditionally performed well during periods of heightened stock market volatility.

“In some cases, high-rated collateralized loan obligations (CLO), commercial mortgage backed securities (CMBS) and other structured products offer spreads in the 1.5% and 2% range,” Tipp told Financial Advisor. “We see these as very attractive and that’s before going into the lower-rated area of investment grade whether that be in financials or whether you move into high yield again away from the extraction sector.”

Karissa McDonough, chief fixed-income strategist with People's United Wealth Management, recommends advisors focus bond portfolios on core bond allocations, such as treasuries, government securities, mortgages and investment grade corporate bonds.

“Core bond allocations now represent more than 80% of our tactical fixed-income portfolio, which is a 10 percent to 15 percent rise over the allocation we had recommended to clients two years ago,” McDonough said. “In taxable portfolios, municipal positions may be substituted for a large portion of the core allocation depending on the client’s tax bracket.”

While advisors can do their own due diligence to invest in stand-alone structured products, they also can consider packaged product versions of these strategies, such as the iShares CMBS ETF (CMBS), which seeks to track the investment results of an index composed of investment-grade CMBS. 

“Advisors should also consider how the underlying portfolios for CMBS and CLO, which could contain both fixed- and floating-rate instruments, might perform in a gradually rising interest rate and slow economic growth environment in comparison to other available products or strategies to help meet their growth or income objectives,” said Walsh, who advises 20,000 clients in New Jersey and Florida.

If there is an unexpected downturn in the U.S. economy, the main option for policy makers is quantitative easing (QE) or negative interest rates. However Tipp said QE has not been a policy that the Fed has liked or seen as cost effective. The Fed ended QE in October 2014.

“If you’re in an environment where the central bank is trying to stimulate the economy but they are charging banks and hurting their earnings profiles, there is a conflict there,” Tipp said. “The Fed would much rather have higher interest rates to begin with so that they can cut in an emergency.”

Even though U.S. interest rates are already incredibly low, they remain attractive relative to the rest of the developed world.

“Another round of QE on the part of the European Central Bank will only serve to drive competing interest rates lower, meaning that there is effectively a ceiling on U.S. rates,” McDonough told Financial Advisor.

The European Central Bank left its benchmark refinancing rate steady at a record low of 0.05% and put its asset purchase program on hold on January 21.

Meanwhile, McDonough believes that investors should retain a strategic allocation to high yield through an actively managed, higher-quality mutual fund. 

“We have also lengthened duration to at least match the Barclays Aggregate Index, which is currently about 5.5 years, as we believe that interest rates, especially longer-term rates, are beholden to the bond market’s view of slowing global growth and risk aversion, and therefore will not be moving upwards significantly over the near- to intermediate term,” she said.