Bond giants lay out their top trades for 2018

It turns out 2017 was a good year to be a bond investor -- if you picked the right spots. Next year presents plenty of potential pitfalls, from divining the path of inflation to determining whether tight credit spreads can persist.

Bloomberg has drawn together views from money managers who oversee a combined total of more than $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.

BlackRock Inc., which oversees $1.78 trillion in fixed income, favors 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 selloff, 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 U.S. municipal bonds, U.S. 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 U.S. yields around their highest level since 2008.

Inflation is finally going to accelerate in 2018, and you'd 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 Inc.'s 2016 fixedincome fund manager of the year award for overseeing the Fidelity Total Bond Fund.

O'Neil's primary goal is preserving gains of the last 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 O'Neil's favorite emergingmarket countries. Short- and intermediate-term debt from "national champion" banks in large European countries also look good.

"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 $500 billion in active fixed-income.

Swell said in an interview that he expects inflation will surprise higher, leading the U.S. yield curve to steepen -- in contrast to the relentless trend in the final months of 2017. He's 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 normalization 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," Swell said.

He likes emerging market debt: specific countries include Hungary, Poland, the Czech Republic, Mexico, Brazil and Colombia. He's avoiding currencies that have significant exposure to China.

Europe just looks healthy," said Bob Michele, who oversees $483 billion as head of global fixed income, currency and commodities at JPMorgan Asset Management.

For that reason, he's buying European additional tier- 1 securities and high-yield debt. When hedged back to dollars, the bonds yield about 5 percent. The biggest risk "is that inflation picks up, the Fed does four hikes, not three, and without QE suddenly you get some steepening of the curve," Michele said in an interview. He expects that to play out.

Under that scenario, shortterm rates could rise 75 to 100 basis points, while the long end jumps 100 to 125 basis points.

Michele hedges away much of the interest-rate risk in his portfolio with futures. Credit spreads, though they've tightened, still have room to absorb broad interest- rate increases, in his view. What doesn't he like? Anything the European Central Bank bought.

Emerging markets, on the other hand, are a winner -Indonesia, Brazil and Russia in particular. "Between those, you get a yield of about 8 percent, and that looks very cheap relative to the developed markets," Michele said. Pimco, which oversees $1.7 trillion, also says a leading risk is rising U.S. 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 in an interview that markets have probably frontloaded the benefits of U.S. tax changes and fully priced assets are setting the stage for uncertainty in 2018.