Risk Rising In Fixed Income

Municipal and investment-grade corporate bonds also are doing better than comparably priced Treasurys, he says. “The market supply of muni bonds is anemic, yet demand for tax-exempt income is as high as ever,” although issuance did pick up somewhat late in the year. The yields will be 1% to 3%, “a little better than Treasurys,” says Valeri. “It’s prudent to expect weaker bond returns.”

Tony Destro is a portfolio manager for Lockwood Advisors Inc., a registered investment advisor and affiliate of Pershing and BNY Mellon that currently manages $12 billion in mutual fund wrap and unified managed account platform assets.

“We won’t see higher coupon returns due to today’s rising interest rates,” says Destro, who expects a prolonged period of rising rates over the next several years.

“Active managers within fixed income tend to fare best in rising interest rate environments,” says Destro, “especially with concerns over liquidity.” That’s why he’s gravitating toward “opportunistic bonds” for yield, an asset class Morningstar calls “a non-traditional opportunity set.” His research group looks for non-benchmark-centric active managers who are free to choose securities and strategies outside the Barclays U.S. Aggregate Bond Index and who are specialists in a non-traditional segment of the fixed-income market or strategy.

As the country moves toward higher interest rates, Lockwood is transitioning his clients from index ETFs to mutual fund wraps and actively managed mutual fund portfolios. Lockwood is seeking to mitigate interest rate sensitivity in its portfolios with shorter duration bonds and floating-rate bank loans. “We’re combating the rate risk through asset allocations,” says Destro, allocating to such things as floating-rate bond mutual funds and emerging market debt.

At BlackRock, the largest provider of passive and active ETFs, chief investment strategist Jeffrey Rosenberg expects “falling oil prices to function as a stimulus package for the U.S. economy,” which will allow the Fed to offer less support.

Fed rate hikes will have the largest impact on shorter maturity bonds, while the impact on longer duration bonds is uncertain due to low global yields and the decline in fixed-income supply, says Rosenberg. “Advisors have been crowding into shorter-term debt for the last five or six years because of the success that was underwritten by a zero rate policy, but BlackRock questions whether this strategy will continue to be successful,” he says. When the rate rises from zero, investors who have been used to low volatility due to ZIRP may need to brace for a new investment environment.

“We’ve had complacency in the financial markets for years, thanks to zero interest rates,” Rosenberg says. “While it’s not 2008 again, we are having a game-changer and a dramatic repricing of financial instruments resulting in changing allocations. There will be big theme rebalancing in bond strategies and rapid repricing of risk.” Overall, though, he says the U.S. economy is looking better. “The U.S. financial markets and USD-denominated assets will be a better place than European and emerging markets.”

One fund receiving strong inflows of $2.4 billion in 2014 was the Loomis Sayles Core Plus Bond Fund, co-managed by Peter W. Palfrey and Richard (Rick) G. Raczkowski, who have run the fund for more than 15 years.

“The cost of manufacturing just went down 45%,” Palfrey says with delight about oil sliding below $55 a barrel. That oil slide spooked investors at first, causing a slide, but the markets have since rebounded.

Palfrey and Raczkowski have been focused on how to find yield when the Barclays U.S. Aggregate Bond Index has been yielding only 2.2%. They like investment-grade, high-yield and emerging market bonds—even those EM bonds in non-dollar securities. Mexico is attracting new manufacturing money that had been going to China, where production costs have gone up, says Palfrey. Mexican labor costs have fallen 12% to 15%, he says.

Deciding that “the U.S. government sector as a whole has become very expensive here,” Palfrey and Raczkowski have allocated just over 30% of the portfolio to the U.S. government market, including Treasurys, agencies and agency MBS—a large underweighting, considering that the index weighting for these three sectors is 70%. Three percent of the government portfolio is in 30-year Treasury Inflation-Protected Securities (TIPS). These Treasury-backed instruments are outside the benchmark, but a favorite with Palfrey, who considers them “attractive long-term inflation protection.”

The fund also has a 30% position in investment-grade credit. It has about 20% in high-yield, 3.5% of which is floating-rate bank loans and the rest of which is in fixed-rate high yield. Another 10% of the fund is in securitized credit (ABS and CMBS).

About 8% of the fund is in emerging markets (in investment-grade countries, paid in local currencies). Of that 8%, 4% is in Mexican peso government debt, 3% is in Brazilian  “AAA”-rated super-national debt, 1% is in Philippine investment-grade government  bonds and 2% is in cash.

Sectors such as high-yield, non-dollar holdings, bank loans, TIPS and other allocations outside the index have historically represented about 18% of the Core Plus portfolio (hence the name, “Core Plus.”) Yet, “These allocations have generated 46% of the fund’s returns over the benchmark over the past 10 years,” Palfrey says.

Sector-wise, “energy stocks and bonds also will be extraordinarily attractive,” in 2015, says Palfrey. “Refiners, midstream pipe providers, oil field servicers, drillers ... all will do rather well based on where they’re priced today.”

We’ll have to wait and see.