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Inflation Outlook Presents Opportunities in Fixed Income

As inflation expectations shift, portfolios will, too. Here are the areas where Deutsche Bank's Gary Pollack sees continued opportunity in fixed income.

As anyone who recently has been to the gas pump can tell you, energy prices are moving higher. The same is true for food prices, which rose 25 percent last year in the global market, sparking riots in Algeria and an export ban in India.

Yet inflation at the consumer level in the U.S. has been minimal so far, mostly due to a weak labor market and high unemployment. That, however, is likely to change, as the two-year-old economic recovery gains momentum, boosting employment and income and allowing businesses more room to pass their cost increases along to consumers. “For the most part, inflation expectations have been minimal. But inflation will slowly emerge as a risk factor in 2011 as people reshape their expectations,” says Gary Pollack, head of fixed income trading and research at Deutsche Bank Private Wealth Management in New York.

Inflation increased 1.5 percent last year before seasonal adjustments, according to the Bureau of Labor Statistics. Economists surveyed by Bloomberg expect that figure to rise to 1.7 percent this year and 1.9 percent next year. That’s hardly a catastrophe — it’s well-within the Fed’s unofficial target range of 2 percent.

It’s a meaningful change, though. And as inflation expectations shift, portfolios will, too. Here are the areas where Pollack — who helps oversee $12 billion in assets — sees continued opportunity in fixed income.

For the most part, Pollack sees little of interest among investment-rated corporate debt. “I find that the Microsofts and Johnson & Johnson’s have little value right now,” he says. The one exception is investment grade-rated financial companies. These institutions were beaten down during the financial crisis. Yet they are now reducing loan-loss reserves, and at least some of the regulatory uncertainty in the sector has been removed, now that Dodd-Frank financial reform has been signed into law.

“Cleaner balance sheets and credit quality help these companies from a bondholders point of view,” Pollack says. Earnings vary from company to company. JPMorgan’s earnings for the fourth quarter looked good, and Citigroup, once given up for dead, is doing well enough that the Treasury is expected Tuesday to auction off its remaining warrants for company stock. Bank of America earnings remain troubled, troubled, as do those of many small and mid-sized lenders. “But earnings are more of an issue for equity investors, Pollack says.

Spreads for financial credit with a 10-year maturity are 150 to 175 basis points, and spreads for five year maturities are 65 basis points to 145 points, according to Pollack. While those spreads have tightened a bit, he says there’s still more upside.

He also looks for value in the taxable municipal bond market. While the headlines are filled with stories about troubled state and municipal finances from California, to Illinois, New York, New Jersey and Pennsylvania, Pollack says there’s selective opportunity here . “The vast majority of municipal issuers will meet their obligations,” he says. ‘But when it comes to some of the weaker credits, be careful.”

He favors issues with mid-range maturities of four to seven years, where he says spreads are in the 50 basis point to 200 basis point range for riskier issuers such as California. He says the potential for spreads to tighten further.

The high-yield market also entices Pollack. “Spreads have come in quite a bit, but they can narrow some more,” he says. At the height of the financial crisis, spreads of high-yield debt peaked at about 2,000 basis points over Treasuries — compared to 400 before the financial crisis. That spread has dropped to about 500, in the midst of a powerful bull market for speculative debt. But he believes it still has some room to go and that high yield spreads could drop to 450 over the near to intermediate term.

As the financial crisis took hold, investors sought the safety of Treasuries and top-rated corporate bonds. As the economy slowly recovers, the willingness to take on risk is back. That will drive a lot of money into equities. But there still are a few fixed-income sectors with appealing yields and manageable risk.

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