As any good sailor will tell you, when the tailwinds shift direction and become headwinds, it’s time to pull out the charts and devise a new course to get to your destination.

That’s an apt analogy for income-seeking investors these days as the major central banks in the U.S. and Europe migrate away from an extended period of accommodative monetary policy. Soon enough, both the Federal Reserve and the European Central Bank (ECB) will remove the proverbial punch bowl by shrinking their balance sheets and gradually raising interest rates.

That shift is bound to have a profound impact on both bonds and income-producing equities. Before we look into the risks—and the opportunities—of these shifting winds, let’s gauge how interest rate policies will likely play out over the next 12 months.

A Modest Shift, But Not Without Risks
Central banks are well aware of the risks associated with changes in monetary policy, so they’ll be taking a go-slow approach. The U.S. Federal Reserve, for example, is only expected to raise rates once more in 2017 (in December) and perhaps three times in 2018, according to Mike Foggin, co-manager of the Fidelity Advisor Global Credit Fund (FGBZX).

Even after those moves, “we’ll still be a long way from normal,” says Aaron Anderson, senior vice president of research at Fisher Investments. Like many other strategists, he thinks that central bank-led interest rates will remain below historical averages for quite some time to come. Foggin doesn’t expect the ECB nor the Bank of Japan (BOJ) to raise rates at all in 2018.

But it’s not just benchmark lending rates that are in play. Both the Fed and the ECB will soon start to unwind their balance sheets by selling off some bonds while letting others mature. But the steady buying hand of central banks will surely no longer provide the support that it has (though Japan may keep its foot on the monetary gas for a while to come).

The Fed, the ECB and the BOJ have each bought more than $4.5 trillion in loans in recent years to help keep demand for bonds ahead of supply. It’s not clear that such moves helped to stimulate the respective economies, but they did usher in an era of stunningly low interest rates.

In anticipation of monetary policy shifts, yields have already moved up from the all-time lows, and won’t necessarily rise a significant amount more from here. “A lot of this is already priced in, and the market should be able to cope with a rise in rates as the removal of stimulus is likely to occur over a number of years,” says Angus Sippe, a multi-asset portfolio manager at Schroders.

Scott Service, a portfolio manager for the global fixed-income product team at Loomis Sayles, thinks the yield on U.S. 10-year Treasurys will rise to just 2.75% in the next 12 months. Longer-dated bonds partly reflect inflation expectations, and “we’re seeing lower inflation reports across the globe,” he says. Still, any increase in rates is a negative for bond prices. Bonds with longer duration would feel the greatest pain.

And some strategists see potential risks in the transition from easing to tightening. Noting that the easing cycle has been in place since 2009, “many investors have forgotten how bond markets normally operate,” says Brian McMahon, chief investment officer of Thornburg Investment Management. As for the coming reversal, “nobody knows where this goes because there is no precedent.” He adds that Thornburg is mostly avoiding the bond market these days.

Former Fed chair Alan Greenspan is especially vocal about his bond market concerns these days. “By any measure, real long-term interest rates are much too low and therefore unsustainable,” he recently told Bloomberg News, adding that “when they move higher they are likely to move reasonably fast.”

Sail To The East
Even as domestic and European bonds carry both low yields and the risk of falling prices, Asia and the emerging markets are shaping up to be appealing options for fixed-income investors. PIMCO portfolio manager Alfred Murata, in a written response to Financial Advisor, notes, “We continue to find select opportunities within [emerging markets] given the high real yield differential to developed markets and starting valuations.”

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