Outside-IN

How to position fixed-income portfolios for rising rates and volatility

Benchmark hugging will not benefit most investors, so advisers must look far and wide for opportunity

Sep 28, 2015 @ 1:54 pm

By Tom Marthaler

Even though the Federal Reserve declined to hike interest rates earlier this month, we still believe rates will rise modestly in late 2015 and proceed at a moderate pace thereafter. Given this backdrop, advisers are wondering how best to position their clients' fixed-income portfolios to manage increased volatility and find yield. Now is a particularly important time to have an active, nimble portfolio and acknowledge that benchmark hugging will not benefit most investors.

Despite concerns about China's slowing economy and the recent turbulence in stock markets worldwide, the U.S. economy is delivering steady, albeit unspectacular, growth. As a result, the Fed will likely begin normalizing interest rates later this year, and so we prefer credit risk over Treasuries. Many market observers believe stock and bond valuations are stretched, but past tightening cycles have demonstrated the attractive upside potential of risk assets even when rates start to normalize.

Within fixed income, domestic credit looks more attractive than developed-market sovereign debt, as the default rate is expected to remain low and rock-bottom (even negative) core-sovereign-bond yields may encourage investors to explore riskier options.

Our investment team is slightly more positive on investment-grade fixed income as yields have risen modestly in the short term, corporate balance sheets are strong, fundamentals remain sound and maturities have generally been pushed off in the distance. As a result, investors are being adequately compensated for owning investment-grade credit relative to very low yields available in sovereign safe assets.

That same logic applies to high-yield fixed income and hard-currency emerging-markets debt, which remain two standouts in fixed income.

Our strategic income strategies are slightly overweight high yield and we anticipate that an elongated business and profit cycle should lend support to this asset class over the next 12 months. Valuations, based on current high-yield spreads, do not appear to be overly extended. Meanwhile, we expect oil prices to stabilize. Inflation, interest rates and central bank outlooks are relatively moderate across the board, contributing to a more benign backdrop for non-investment-grade fixed income.

At the same time, we are currently underweight U.S. Treasuries. Recent data including on the housing market, consumer spending and the labor market suggest prospects may improve during the next few quarters.

Outside the U.S., the eurozone economies are improving modestly with business and consumer sentiment continuing their slow recovery. High unemployment, however, still weighs on domestic demand in the eurozone countries. Downside risk in the region remains elevated with potential impediments including political instability, lingering “Grexit fears,” and volatile negotiations surrounding the appropriate framework for support mechanisms within the currency bloc.

Likewise, emerging markets seem to be stabilizing, making their attractive yields worth the associated risk.

Perhaps now more than ever, investors and their advisers should consider actively managed and nimble fixed income portfolios that have the ability to invest anywhere across the fixed income landscape seeking upside while managing risk.

Tom Marthaler is managing director and portfolio manager at Neuberger Berman.

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