It all comes down to rates

Advisers can relax, at least a bit. The bond bubble probably won’t be popping this year. The flight-to-quality mentality that has kept rates low should subside once the budget debate in Washington is over. So with Treasuries expected to be under some pressure, strategists suggest finding yield in non-investment-grade credits, which can benefit from compressed spreads and avoid the huge interest rate risk of high-quality long-duration bonds.

Most observers expect the rate of the bench-mark 10-year Treasury note to move above 2% and close in on 2.5% to 3% by year-end.

A sharp rise in rates isn’t on the immediate horizon, however.

Last month, the Federal Reserve took historic action in linking monetary policy to specific economic targets. The Fed said it will keep the federal funds rate low until unemployment falls below 6.5% and inflation is forecast at less than 2.5%. The Fed’s action was considered a bearish statement on the U.S. economy.

Sluggish economic growth is why one of the very rare bond bulls, Richard Bernstein, founder of Richard Bernstein Advisors LLC, predicts that yields on long-term U.S. Treasuries will continue to fall. He also feels that the overwhelming negative sentiment on Treasuries is bullish.

“Whenever you think something is a sure thing, that’s when your antennae should be signaling a warning,” Mr. Bernstein said.

David Pequet, president of MPI Investment Management Inc., couldn’t disagree more.

“We think there’s definitely a bubble in longer-dated bonds, across the board,” said Mr. Pequet, whose firm runs short-duration portfolios for institutional investors.

“The market has become very complacent,” he said. “People hear [the Fed say] low rates will go to 2015 or 2016, so they figure that’s a sign to gather as much yield as possible and take a free shot. But it doesn’t happen that way.”

Mr. Pequet recalls when the Fed raised rates six times in 12 months, beginning in 1994, after a surprisingly positive employment report.

Advisers as a group also seem pessimistic. InvestmentNews’ 2013 Investment Outlook survey, with 592 advisers participating last month, found that only 12.9% of advisers will be recommending that clients increase their allocations to U.S. fixed income this year. Similarly, only 17% will suggest that clients boost their international fixed-income holdings, and 4.4% will recommend increases to Treasuries.

“There will be another [bond] panic,” suggested Michael Mata, head of multisector fixed-income strategies at ING Investment Management Americas. Like most observers, though, he doesn’t think the interest rate dam will break this year.

So what’s an adviser to do with fixed-income allocations?

2013 BOND STRATEGIES

“Keep [bond] quality high and keep durations in the 3.5- to four-year range,” Mr. Pequet said, despite the fact that yields on such a portfolio are skimpy.

Investors needing income should take on credit risk rather than duration risk, said Jeff Rosenberg, chief investment strategist of fixed in-come at BlackRock Inc.

BlackRock is warning investors away from safe-haven bonds, recommending instead global high yield, emerging-markets debt, commercial-mortgage-backed securities, collateralized loan obligations and municipals.

Mortgage-backed securities, for example, should benefit from improving real estate and lending environments, Mr. Rosenberg said.

“Unlike in past years, you’ve got some real conviction about a housing turnaround,” he said.

Robert Tipp, chief investment strategist for Prudential Fixed Income, also likes emerging-markets debt, high yield and debt from European peripheral countries.

LESSENED RISK

Prices on these securities should hold up, driven by diminished supply from continued deleveraging as well as steady demand from investors and central banks, Mr. Tipp said.

Advisers agree. The InvestmentNews survey found that 32.8% of advisers will recommend that clients increase their allocation to emerging-markets fixed income in 2013.

Strategists also think a declining U.S. dollar could boost a variety of foreign sectors.

The Fed has been the most aggressive central bank in keeping rates low, which will put pressure on the dollar, Mr. Mata explained.

The dollar has held up amid global uncertainty and volatility, but global deleveraging has lessened the overall risk in the system, Mr. Tipp added. “We’re seeing that [flight-to-quality trade] begin to unwind.”

High-yield bonds, mostly a U.S. asset class, still have fans after several years of strong performance.

Spreads are more than 500 basis points over Treasuries, “so you have room to tighten” should Treasury yields rise, said Kevin Nicholson, director of portfolio risk strategy at RiverFront Investment Group LLC.

“There’s not much capital gain potential on high yield, though. You’re going to get your coupon,” he said.

Sabur Moini, portfolio manager of the Payden High Income Fund, agrees with that assessment.

“But historically, when rates have gone up, high yield has held up better” than Treasuries and investment-grade bonds, Mr. Moini said. “You really have no cushion at 2.5%” yields from investment-grade debt, he said.

The outlook for municipal bonds is up in the air until their tax status is clarified.

“All else being equal, yields should edge higher” this year, said Matt Fabian, managing director at Municipal Market Advisors Inc. New-issue volume should drop and default trends will improve, he said.

However, if the muni bond tax exemption is altered, “all those [predictions] go out the window,” Mr. Fabian said.

Municipal Market Advisors estimates that a 28% tax rate cap on the muni tax exemption would force yields up by 40 to 75 basis points. That would be an “enormous” impact, given the sub-2% yields on high-quality 10-year bonds, Mr. Fabian said.

How all the uncertainty in fixed-income markets actually will shake out this year is anyone’s guess.

In a report last month, Mr. Rosenberg wrote: “In 2012, everything went right for fixed-income returns; next year will be more challenging.”

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