While they wait for interest rates to rise and a chance to reinvest for greater yield, advisers remain parked in short-duration, high-quality fixed-income instruments.
It may make sense to put another quarter in the meter.
“For three years now, the wildly [popular] consensus was that yields were going higher. But the 10-year [Treasury note] is again breaking below 2%,” Gibson Smith, Janus Capital Management LLC's co-chief investment officer for fixed income, said in mid-December.
“The flight-to-quality trade, the risk-free trade, is alive and well,” he said. “It makes sense when you overlay all the [political] dysfunction” in the U.S. and Europe.
The failure by European leaders to come up with a permanent solution to the debt crisis has led to fears of bank failures there and in the U.S. as well, where monetary and fiscal options to deal with a crisis are seen as far more constrained than in 2008.
"NERVOUS MONEY'
“There's no doubt that there's a fear trade — a lot of nervous money both abroad and domestic seeking to be in liquid, safe investments,” said Kenneth Naehu, managing director and portfolio manager of fixed income at Bel Air Investment Advisors LLC, which manages $7 billion for clients.
Meanwhile, the economy is making little headway, giving the Federal Reserve no reason to boost rates.
“I think people who are waiting for rates to go up before investing are probably mistaken,” said Robert Tipp, managing director and chief investment strategist for Prudential Fixed Income. “It will probably be a couple of years before the Fed raises rates.”
The nation's central bank has made clear that it expects to stick with its zero-rate policy on the short end at least through mid-2013, and its latest “Operation Twist” program of reinvesting its cash flow into longer-dated bonds is seen as an effective means to keep rates down on the long end.
Demand from bond buyers also remains strong, which helps keep a lid on rates, observers said.
“Given investor appetite, changing demographics and underfunding of pensions, demand remains very high,” Mr. Tipp said. “And foreign investors continue to come into the fixed-income markets. There's a lot of saving going on in world, particularly in developing countries.”
But low rates on the benchmark Treasury don't mean stability for the bond market as a whole. Observers expect manic-depressive-type moves in the credit markets as headlines drive action in the near term despite fundamentals.
“There are going to be multiple points where ... the market is going to overreact if it thinks inflation is heating up, or a country in Europe is failing,” Mr. Naehu said.
“Our mantra is to be ready for extreme volatility and be ready to take advantage of it,” he said.
CORPORATE SECTOR
Fixed-income analysts say opportunities are best in the corporate sector, where improving fundamentals and attractive spreads over Treasuries should provide relatively good returns even if interest rates rise.
“Especially in corporate bonds or structured products, where you're picking up multiples [of 10-year Treasury yields], when rates begin to rise, a lot of that [drop in bond values] will be offset by compressing spreads in these other [corporate] sectors,” Mr. Tipp said.
Spreads on corporates remain attractive, with investment grade paper at 1 to 2 percentage points above Treasuries, with lower-rated bonds offering 6%-plus, Mr. Tipp said.
“The area of the [corporate bond] curve we prefer is out 10 years or longer with ... a bit more yield” over Treasuries, said Rick Rieder,
BlackRock Inc.'s chief investment officer of fixed income.
That area should provide some cushion from higher rates, he said.
Mr. Rieder expects spreads on corporates and municipals to narrow as rates on the 10-year Treasury rise by between 50 and 75 basis points this year.
Solid fundamentals in the corporate sector should support narrower spreads, observers agreed. Corporate balance sheets are more de-levered than households or governments, profit margins are strong, cash is building, and there's no sign that companies are beginning to add debt.
“In an environment where there's a lot of hot [political] rhetoric and a lot of uncertainty, one way to sleep at night is to focus on great companies with fundamentals that are improving and balance sheets that are de-levering,” Mr. Smith said.
He thinks investment-grade spreads could tighten by 30 to 50 basis points this year, and high-yield spreads could fall by between 150 and 200 basis points.
Mr. Rieder also likes emerging-markets debt.
“Especially in fixed income, we see opportunities emanating from sovereign and corporate issues,” he said.
But there's a near-term caveat: The European situation “is still fluid and a lot of financing in the emerging world comes out of the European financial system,” Mr. Rieder said.
Don't completely forget about those low-yielding U.S. Treasuries. They're useful as a hedge against bad news.
“We're using longer-duration Treasuries to hedge some of the volatility [and] preserve capital on the downside,” Mr. Smith said.
Treasuries even have the potential to rise in price when the economy worsens, Mr. Tipp said, as they still have yields higher than those of competing safe-haven German and Japanese bonds.
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