Bond experts agree there are still viable places for investors to park fixed-income dollars this year despite sharply narrowed credit spreads, high valuations and the start of a global pullback in monetary accommodations.

Even with the end of the business cycle just a year or two away, “we’re certainly not by any stretch of the imagination ringing the alarm bells that investors should be moving out of fixed income,” says Lisa Black, the head of taxable fixed income at Nuveen, TIAA’s investment management unit.

However, Black, who oversees Nuveen’s $280 billion in taxable fixed-income assets, and her industry peers emphasize the importance of being much more discerning this year with bonds. “Investors who do their homework or deep credit work can ferret out the winners from the losers,” she says.

Black doesn’t see much opportunity this year in Treasurys and agency securities given the low level of rates and a flatter yield curve. Nuveen projects the 10-year Treasury to yield just 2.6% to 2.75% by year’s end. She says the three areas in which the firm sees value and will continue to focus its investment activities this year, albeit selectively, are investment-grade, high-yield and emerging market debt.

In investment-grade debt, Nuveen is overweight in banking (a beneficiary of rising rates) and REITs (because of their strong covenants and cash-flow generation). The firm is slightly overweight in energy, including pipelines and integrated energy companies. One sector it’s underweight in is technology, because of the industry’s rich valuations.

In high yield, Nuveen is overweight in services (e.g., equipment rental companies, engineering and design, and home security) and chemicals, but it’s underweight in telecom, banking, and metals and mining. Black is concerned that very tight spreads aren’t compensating for credit risks. Highly leveraged companies that can’t fully deduct interest expenses because of the new tax law’s 30% cap will be worse off financially than companies that can fully deduct these expenses, she adds.

She is also focusing on wage pressures. If they heat up, it will raise inflation and, in turn, warrant sharper rate hikes. For now, the Fed expects to gradually raise the federal funds rate three times in 2018, following its three quarter-point hikes in 2017.

The “war of words” with North Korea hasn’t led to a flight to quality in fixed income, says Black, and she doesn’t expect to see any major market moves if this rhetoric continues. But if the U.S. and North Korea actually go to war—which is not Nuveen’s base case—she thinks that would impact all markets.

Unchartered Territory

Investors have been forced into risk-on mode (chasing riskier assets in search of yield) ever since the Fed initiated quantitative easing in 2009, says Mark MacQueen, co-founder of Sage Advisory Services, an Austin, Texas-based RIA firm that manages approximately $11 billion in fixed-income assets. Although just about anything risky has paid off significantly, he says, “Much of that payoff has been taken, the market has taken it, and the next big move will be a risk-off move.

“We’ve pushed this market into unchartered territory,” says MacQueen, noting that, according to Deutsche Bank, 17% of the $48 trillion non-U.S. bond market was trading at a negative yield in late 2017. At this point, the “frothiness” of the market could quickly reverse, triggering “somewhat of a rush for the door,” he says. This could create liquidity issues in 2018 and 2019, he says, particularly for the largest bond players.

In addition to valuations, “cycle age and policy unwind are big concerns for the market going forward,” he says. Central banks are starting to unwind their policies now that global growth is synchronized across regions and picking up, he says. In November, the Bank of England raised rates for the first time in nearly a decade. The European Central Bank and the Bank of Japan are tapering their quantitative easing.

MacQueen thinks interest rates will remain very tame because the drivers of long-term growth and long-term inflation are absent. “The demographics, the Amazon effect and the internet effect have put a lid on runaway inflation,” he says. “The aging population is done with their spending and the money is not flowing.”

Sage Advisory is maintaining its durations as a defense against a possible flight to quality. “We think that owning enough duration hedges you against some of the spread risk you’re taking, he says. The firm has also removed high yield from its accounts and is primarily using bank loans as a substitute to try to capture yield with less risk, he says.

Mark Kiesel, the chief investment officer of global credit at Pimco (which in total has $1.7 trillion in fixed-income assets under management) expects to see a slight uptick in interest rates this year across the U.S. and several other developed economies, including the U.K., Europe and Japan.

“Global profits are synchronized, and you’ve got this liftoff,” says Kiesel, adding there are no real weak spots like there were two years ago when energy prices were under significant pressure. Tax cuts and support for the equity market in the near term will also help fuel easy financial conditions and, in turn, lead toward a bias of higher rates in developed markets, he says.

Kiesel, who manages the Pimco Investment Grade Corporate Bond Fund (PIGIX, AUM: $12 billion), has been less optimistic about fixed income in developed markets because of their bias toward higher rates. He’s rotated some assets to emerging markets where he sees catalysts for lower rates. “Brazil has been a big winner for us,” he says. The portfolio also has exposure to Mexico and Argentina.

The fund is overweight in financials, which he thinks will be one of the biggest beneficiaries of higher rates and a steepening yield curve (which he expects to see as money supply is increased to fund a growing deficit resulting from a tax stimulus package.)

The Pimco Investment Grade Corporate Bond Fund has long avoided the retail sector (for the “Amazon effect” and other reasons, says Kiesel), but it is focused on such consumer-oriented sectors as gaming, lodging and airlines. Consumers across the globe are doing better, U.S. consumers will benefit from tax cuts and these sectors are performing well, he says. People are spending more money on services and experiences instead of “stuff,” he adds.

The fund is overweight in the housing and building materials sectors (which have finally started to recover) and has big investments in pipelines and midstream energy companies. “The shale revolution has been a game changer and will continue to be a game changer,” says Kiesel.

Overall, he’s moved to a more defensive position in terms of overall exposure in the credit markets, he says. He’s also added bank loans to the fund because they float and can benefit modestly in a higher rate environment.

Muni Mania

David Kotok, the co-founder and chief investment officer of Sarasota, Fla.-headquartered RIA firm Cumberland Advisors (which has dedicated approximately $2.5 billion of its $3 billion in assets to fixed income), thinks the entire Treasury curve will “ratchet higher” over the next 12 to 18 months.

“How much higher? I don’t know. How violently or benignly, I don’t know,” he says. But the Fed is bent on raising short-term rates, he says, and the additional debt it will need to issue to fund a rising deficit will affect intermediate and longer-term rates.

Kotok also anticipates a “shrinkage tantrum”—the term Cumberland Advisors has coined for the chaos that could descend upon financial markets following a pullback in accommodations by the Fed and other central banks. The Fed is starting to shrink its balance sheet in “baby steps” because it doesn’t want to shock the markets, he says, but this shrinkage will accelerate at the same time the Fed will increase the money supply to tackle the deficit.

Kotok is feeling less optimistic about Treasurys and has negligible holdings in high-yield bonds because the 10-year chase to high-yield has driven spreads to a very narrow level. “I’m favoring the municipal turf, taxable and tax-free, not the corporate turf sector, because that’s where the bargains are,” he says.

Cumberland is very selective on individual issuers and has sold down or completely eliminated munis from some troubled states that aren’t addressing budgetary issues. “Illinois is the poster child” for that, says Kotok, along with nearly a dozen other states (including New Jersey, Connecticut and Kentucky). The tax bill will make it harder for these states, he says, because they tend to have higher real estate taxes and higher income taxes.

John Miller, head of municipals at Nuveen, sees opportunities in high-yield munis. The projects they finance may be similar to those of mature, higher-quality credits (they fund things such as infrastructure for new neighborhoods, hospitals, charter schools and industrial development revenue projects) but the projects are at an earlier stage of development, he says, and successful ones can reach higher credit ratings over time.

High-yield munis tend to have historically low default rates and higher recovery rates than equivalently rated corporate bonds, he says, but they can face sharper declines if the muni market enters risk-off mode (the move to safer assets).

Different Perspectives

Colin Robertson, head of fixed income at Chicago-based Northern Trust Asset Management, which managed $529 billion in total fixed-income assets as of September 30, is an outlier among a sea of industry trackers who expect the Fed to raise rates three or, like Goldman Sachs, even four times in 2018.

“I see an 85% chance the Fed raises less than three times, 75% [chance] less than two times and a 50% chance it doesn’t move at all,” he says. “We think market participants are overblowing the speed with which these accommodations will drop away.” His slow rate forecast is also predicated on Northern Trust Asset Management’s outlook for “stuckflation”—its term for inflation remaining below the Fed’s 2% target.

In the longer term, central banks are “always in some way, shape or form going to be more accommodative than they ever were before,” adds Robertson. Economic growth has been more muted than central banks anticipated, he says, and this may represent a structural change to economies.

Like others, he doesn’t expect new Fed chair Jerome Powell to shake up Fed policy. At least initially, “he seems very Yellen-like in his verbiage,” says Robertson.

“It absolutely makes sense for investors to still be in high yield,” says Robertson. “I don’t see any type of crash around the corner.” Although investment grade and high-yield spreads are historically narrow, he thinks they can contract further. The real key, he says, is doing credit research from the bottom up on companies.

James Swanson, chief investment strategist of MFS Investment Management, advocates a very high-quality approach to corporate bonds because investors aren’t being compensated enough to pass the biggest hurdle in high yield—defaults. These are at record low levels, but he questions if that’s sustainable.

Even in high-grade bonds, investors must look ahead to potential disruptors, he said during MFS’s year-end outlook webcast, pointing to the impacts of Spotify on the music industry and Uber on the cab industry. “You better make sure you’re on the right side of winners and avoid the losers,” he said, “because when the losers lose, the capital losses are immense.”

Swanson also cautioned that bond ETFs have yet to be tested in a prolonged bear market. And while they may be purported to be very liquid, it depends on their underlying assets. There are many idiosyncratic elements of owning a bond, he said, such as covenants, coupons and call features. “Each one is different,” he said. “They’re not fungible.”

Finally, don’t get too caught up in fixed-income outlooks. “Markets can always go contrary to what you think,” says Kiesel of Pimco, “so you have to be humble about this.”