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Fixed Income: A Delicate Balance

An Institutional Investor Sponsored Statement

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By Howard Moore

The fixed-income market is beginning to diverge by country, type of instrument, and even investment thesis. Success requires careful portfolio construction that balances risk.

Fixed-income investors have had it good the past few years. As central banks cut rates to support their respective economies, the fixed-income market has been able to generate strong performance driven by duration. Everything performed.

That is all changing, however, as bond markets start to exhibit more divergence.

While the Federal Reserve is expected to boost interest rates in the U.S. within the next year, many other countries continue to lower them. Furthermore, says Arif Husain, head of international fixed income at T. Rowe Price, the various types of fixed-income instruments themselves — governments, corporates, and mortgages, for example — are following increasingly distinct market patterns, even down to individual companies. “This divergence is what will lead fixed-income performance going forward,” Husain says.

It is changing the very thesis of fixed-income investing, in fact. “Investors are now having to decide what they expect from fixed-income allocations,” says Husain. Income investors must accept a level of volatility associated with higher-yielding instruments — “which is fine over the long term,” he notes. Others believe that right now the fixed-income portfolio is best used as a defensive instrument providing diversification in times of equity market stress. “Increasingly, we see investors at these extremes, based on their own risk appetites and investment objectives,” notes Husain.

Either way, in a fragmented market the key to success is skillful portfolio construction. “We have to balance risk thoughtfully and consider the interaction of the various elements,” says Husain. An unconstrained strategy offers many opportunities. “We can buy U.S. Treasuries, add corporate credit, trade emerging-markets currencies, and hedge against risk aversion scenarios by adding options,” for example. Increasingly, investors are embracing such absolute-return strategies and moving away from standard benchmarks. “Investors are looking for more flexible solutions,” he says.

For income-seeking investors, high-yield debt remains attractive. “It’s performed well this year, helped by a recovery in the energy sector,” notes Stephane Fertat, fixed-income portfolio specialist at T. Rowe Price. He expects that strong performance to continue, especially in Europe, where high-yield issues are less exposed to rising rates. He also likes U.S. bank loans, which can be a good way to generate income without too much risk and may protect against a possible rate hike as well. Emerging-markets debt, too, is gaining ground, with yields in the 4 percent range as fundamentals are generally improving and countries overall display greater political stability. “This is heavily correlated to risk appetite, however, and they can swing very quickly,” he cautions.

In a world of negative interest rates, investors whose goal is defensive must also take care. “Sure, over the long term, buying negative-interest-rate bonds is not profitable for investors,” says Fertat. But in the short term, opportunities remain. Central banks are still providing support to markets, and many banks are reinvesting the proceeds into government bonds. “We can still find opportunities, depending on the market, the cost of hedging, and the shape of the yield curve,” Fertat says.

Whether defensive or opportunistic, however, investors can expect fixed-income decision making to become a more complex matter going forward.

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