“Most of the sell-off in bonds is probably behind us,” Tipp says. He doesn’t think this is the end of the bull market for fixed income, but merely a pause. He expects yields on 10-year Treasurys—which hit a low of about 1.3% in July—to stay in the 2% to 2.5% range until there’s a clear indication that a faster pace of U.S. economic growth will actually be sustained.
The Prudential Total Return Bond Fund, which has nearly $18.6 billion in assets, is likely to remain overweight this year in investment-grade and high-yield corporate bonds, as well as select structured products, says Tipp, and with a somewhat longer average duration than the Barclays U.S. Aggregate Bond Index. By being positioned for interest rates to stabilize or decline, he says, “we’ll get additional yield in the portfolio and possibly capital gains if it turns out that growth expectations are exaggerated.”
The fund has an overweight allocation to energy-related investment-grade corporate bonds but is underweighting high-yield energy. “Energy prices are high enough for the investment-grade companies to do reasonably well,” he says, “but not high enough for us to feel secure with the below-investment-grade.” He also sees other opportunities in corporate bonds, particularly U.S. banks.
Tipp plans to watch the regulatory environment this year to monitor changes that could have ramifications for a variety of corporate sector weightings. Additionally, changes in housing policies could impact the mortgage market, he says.
“The bond market looks very attractive to me,” Tipp says. He thinks that people who stay engaged in it, in a diversified manner, will be rewarded over time, he adds.
Tough Transitions
Gaffney, who manages nearly $1 billion in assets in Eaton Vance’s multisector and core plus bond funds and institutional accounts, also sees attractive opportunities. However, “I do think we’ve seen the lows in interest rates,” she says. “The secular bull market in bonds is over.”
“No matter who ended up in the White House, the end result is we were going to see a pickup in fiscal spending,” she says. Such spending is needed to improve economic growth, which has been insufficient in the U.S. and globally since the global financial crisis began nearly a decade ago, she says.
She thinks it’s time for the markets to focus on infrastructure, inflation and investment—“three words we really haven’t talked about in a long time,” she says, “because monetary policy was doing all the heavy lifting.”
Gaffney, who uses a bottom-up investment strategy, says the biggest chunk of the Eaton Vance Multisector Income Fund (25%) is allocated to currency bonds in developed and emerging economies. Canada, New Zealand and Australia are very sensitive to natural resources, so as inflation picks up, their currencies should appreciate, she says. Mexico and Brazil have introduced many reforms that should help their economies and, in turn, drive currency appreciation, she says.
Nearly 20% of the fund’s assets are allocated to investment-grade corporate bonds. A fair amount of these holdings are energy or commodity related and the fund also has exposure to financial companies and retailers. The steepening yield curve—with yields rising for long-dated as well as short-term securities—makes it easier for financial companies to be profitable, she says.
Another 20% of the fund is allocated to U.S. high-yield corporate debt. Gaffney says many of these holdings are “fallen angels”—formerly investment-grade bonds that were downgraded amid industry challenges but whose issuers tend to have stronger balance sheets and greater financial flexibility. The fund’s holdings include mining companies Freeport-McMoRan and Teck Resources and energy drilling companies Ensco and Rowan Companies.
The Eaton Vance Multisector Income Fund also has approximately 10% of its assets in convertible bonds, 10% in cash, 5% in bank loans, 6% in equities and the remainder in structured products (commercial mortgage-backed securities).
Investors will need managers with a disciplined and solid investment approach to guide them through this environment of rising uncertainty and volatility, Gaffney says. She thinks it’s a good opportunity for active managers, who have fallen out of favor, to add value and demonstrate skill.
Munis And More
Schroders, which manages $53 billion in U.S. fixed-income assets, is expanding its U.S. fixed-income team as part of its growing commitment to this asset class. According to Chorlton, the firm is seeing increased demand for U.S. fixed income from overseas investors in Europe, Asia and Latin America.
“It’s hard to say after the bull market fixed income has been in that this is a new time for bonds,” he says. “I think it’s more a case of recognizing that we’ve punched below our weight.” Still, he sees no shortage of interest or opportunities in fixed income.
The U.S. municipal bond market “is a really interesting place at the moment,” he says. After getting super expensive last summer, muni prices tumbled as massive asset outflows followed the election. In addition to the risk of rising interest rates, investors fear lower taxes promised by President Trump could reduce the incentive to buy tax-free munis and that higher infrastructure spending could increase issuance.
Despite the unfavorable supply-demand dynamics, Chorlton sees a big buying opportunity because munis have corrected aggressively relative to other fixed-income assets. He’s limiting his holdings to good quality liquid issues because he doesn’t think investors are being adequately compensated for those issues when there is higher credit risk and volatility and when there is less liquidity. And investors should be paid more if muni issuers haven’t set aside money to fund their pension plan liabilities, he says.
The Hartford Schroders Tax-Aware Bond Fund also has a heavy weighting in banks, which Chorlton thinks will do well given expectations for a steeper yield curve, stronger economic growth dynamics and “perhaps a less onerous regulatory burden under the new administration,” he says.
Chorlton thinks the Fed could raise rates three times this year, but only if it starts early. “If nothing happens until June or midyear, it would be hard to force three rate hikes into the second half of the year,” he says.
He’s also keeping a close watch on external geopolitical events, particularly in Europe, where frustrated voters in a handful of countries will go to the polls in the coming months to elect new leaders.
There’s no way to escape volatility this year. However, says Chorlton, “There’s always going to be a place for fixed income in most investors’ portfolios.”