Bond returns to look out for this year, by those in the know
Money managers in charge of $7tn-plus offer their views on the best investment picks this year
It turns out 2017 was a good year to be a bond investor – if you picked the right spots. This year presents plenty of potential pitfalls, from divining the path of inflation to determining whether tight credit spreads can persist.
Here we have drawn together views from money managers who oversee a combined total of more than US$7 trillion in fixed-income assets for their perspectives on how to achieve top returns in the year ahead. Some urge caution, although many acknowledge that the global economy looks to be on solid footing.
Here’s a summary of their investment outlooks:
BlackRock
BlackRock, which oversees $1.78tn in fixed income, favours moving up in credit quality, according to its 2018 global outlook. Buying illiquid debt during a rally when everyone wants it may seem safe, but in a sell-off, volatility will spike as the exits get crowded.
“Everyone can take home a trophy when ostensibly low risk is rewarded handsomely. This has played out in global credit markets,” wrote strategists including Jeff Rosenberg. “But the risk inherent in these strategies rises disproportionately as credit spreads narrow.”
The world’s largest money manager doesn’t have any overweight recommendations in the fixed-income section of its 2018 outlook. The firm has a neutral stance on US municipal bonds, US credit, emerging markets and Asian fixed income, and an underweight position on Treasuries, European sovereign debt and European corporate bonds.
Rick Rieder, BlackRock’s global chief investment officer for fixed income, has said he likes the front end of the Treasury curve, with two-year US yields around their highest level since 2008.
Fidelity Investments
Inflation is finally going to accelerate in 2018, and you would do well to have Treasury Inflation Protected Securities to guard against it, said Ford O’Neil at Fidelity, which has $975 billion in fixed-income assets. He and his team won Morningstar’s 2016 fixed-income fund manager of the year award for overseeing the Fidelity Total Bond Fund.
Mr O’Neil’s primary goal is preserving gains of the past two years. He said that he likes owning leveraged loans (as he did to start 2017), given that their interest rates reset higher with Federal Reserve hikes.
Brazil and Mexico are Mr O’Neil’s favorite emerging-market countries. Shortand intermediate-term debt from “national champion” banks in large European countries also look good.
Goldman Sachs Asset Management
“Our highest conviction view is around a reintroduction of volatility,” said Mike Swell, co-head of global fixed-income portfolio management at Goldman Sachs Asset Management, which looks after about $500bn in active fixed income.
Mr Swell said that he expects inflation will surprise higher, leading the US yield curve to steepen -- in contrast to the relentless trend in the final months of last year. He is going short duration and buying steepeners to profit from his outlook.
GSAM suggests owning less corporate credit than usual. The same goes for agency mortgages, which the Fed is shedding as part of its balance sheet normalisation process.
“The potential for credit widening in 2018 is something that’s not really being discussed a lot, but should be on people’s radar,” Mr Swell said.
He likes emerging market debt: specific countries include Hungary, Poland, the Czech Republic, Mexico, Brazil and Colombia. He is avoiding currencies that have significant exposure to China.
JP Morgan Asset Management
“Europe just looks healthy,” said Bob Michele, who oversees $483bn as head of global fixed income, currency and commodities at JP Morgan Asset Management.
For that reason, he is buying European additional tier-1 securities and high-yield debt. When hedged back to dollars, the bonds yield about 5 per cent.
The biggest risk “is that inflation picks up, the Fed does four hikes, not three, and without QE [quantitative easing] suddenly you get some steepening of the curve,” Mr Michele said. He expects that to play out. Under that scenario, short-term rates could rise 75 to 100 basis points, while the long end jumps 100 to 125 basis points.
Mr Michele hedges away much of the interest-rate risk in his portfolio with futures. Credit spreads, though they have tightened, still have room to absorb broad interest-rate increases, in his view.
What doesn’t he like? Anything the European Central Bank bought.
But emerging markets are a winner – especially Indonesia,
Brazil and Russia. “Between those, you get a yield of about 8 per cent, and that looks very cheap relative to the developed markets,” Mr Michele said.
Pacific Investment Management Company
Pimco, which oversees $1.7tn, also says a leading risk is rising US inflation. The money manager expects at least three Fed rate hikes.
Markets are at or near the peak of the current cycle, and investors should become defensive before they turn down. Dan Ivascyn, Pimco group chief investment officer, is calling for underweight positions on duration and low-rated corporate securities.
He said that markets have probably front-loaded the benefits of US tax changes and fully priced assets are setting the stage for uncertainty.
“When valuations are full, small amounts of bad news or new news hitting the market can have a greater impact on volatility,” Mr Ivascyn said. “We’re at a point now where you have much less margin for error.”
Pimco is also betting on a steeper US yield curve. The Fed’s shrinking balance sheet, greater government deficits and less monetary stimulus abroad mean investors will demand a higher premium on longer-term debt.
TCW Group
Tad Rivelle at TCW says investors should take the opportunity now to insure against an eventual downturn, even as the economy seems to be hitting its stride. Years of central bank intervention have distorted interest rates and asset prices.
“When the correction comes, it could come in a more severe package,” said Mr Rivelle, whose firm has $179bn in fixed-income assets.
Fixed-income investors should be content in 2018 with safe returns of 2.5 per cent to 3.5 per cent rather than reaching for risk. Such gains could come from a mix of high-quality corporate bonds and commercial real estate, along with agency mortgages.
A flattening US yield curve could be “public enemy No 1” for investors, Mr Rivelle said. The trend is likely to continue if the Fed sticks to its path and raises rates three times next year. Higher short-term rates may erode the credit quality of some companies with high leverage, he said.
Vanguard Group
The flattening yield curve trend in 2017 represented a “regime change” from the past several years, according to Anne Mathias, senior strategist at Vanguard, which oversees $1.3tn of fixed-income assets. Shorter-term Treasuries were subject to the biggest moves, while the long end remained anchored in a range. Expect that to continue in 2018.
“There are more tactical opportunities in the short end and there’s good, decent longterm stability and yield pickup in the longer end,” she said.
She is also watching the cross-currency basis swap market to gauge demand for US bonds from Japan and Europe. Last month, the hedged yield on 10-year Treasuries fell to a record low.
Western Asset Management
The fund manager with $367bn in long-term fixed-income assets says 2018 will be a lot like 2017. That means stubbornly low inflation and bonds with some added risk – like corporate, emerging market and structured debt – delivering higher returns.
“We’re still optimistic on a lot of the spread sectors,” Western Asset Management deputy chief investment officer Michael Buchanan said.
Central banks may not be able to normalise policy as fast as they want because of modest inflation, her added.
Winning bets include emerging-market local currency debt because of high nominal rates. Also what Mr Buchanan calls “rising star trades,” or bonds likely to receive credit upgrades, since they can add 40 to 70 basis points of spread compression.