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What should bond investors expect in 2020?

Here's a look at what the year ahead may have in store for fixed income.

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Key takeaways

  • The Federal Reserve is unlikely to raise interest rates in 2020.
  • Stay diversified and focus on credit quality.
  • Investors should temper their expectations for return in 2020.
  • Keep some dry powder in case volatility creates opportunities.

In 2019, many types of bonds have delivered some of their best returns in more than a decade. Will 2020 bring more of the same for fixed income investors? Viewpoints spoke with Chris Pariseault, CFA©, Fidelity's Head of Fixed Income and Global Asset Allocation Institutional Portfolio Managers, about what he sees ahead for rates and bonds in the new year.

Do you expect the bond market rally to continue into 2020?

Pariseault: Given the year that we've had thus far, investors should probably temper their expectations for matching that performance in 2020. We're coming off a strong year of price returns, which are hard to replicate back-to-back.

Why shouldn't investors expect 2020 to be a continuation of 2019?

Pariseault: Last year, bond prices rose because the Federal Reserve cut interest rates after raising them in 2018 (bond prices rise when rates fall). I think that rates are probably going to stay in a pretty tight range over the next year unless something unexpected happens.

The Fed's goal when it sets interest rate policy is to influence broad financial conditions. The idea is that low rates are expected to produce stronger growth and higher inflation in the future. However, the Fed has been trying to raise inflation with this strategy for 11 years and inflation hasn't really materialized. I believe the Fed and central banks around the world are more willing to let their economies run a little bit hot with higher inflation before they start to raise rates and we're not near that point yet.

What could change your expectations about rates?

Pariseault: If trade tensions between the US and China start to subside, the geopolitical picture becomes clearer, and governments and central banks around the world provide more fiscal stimulus, those things would certainly be significant tailwinds to the global economy. Increased growth could eventually lead to higher interest rates. But that looks to me like a possibility for 2021, not necessarily 2020.

What can investors expect besides tempering their expectations?

Pariseault: The story for 2020 will likely be about waiting for global growth to occur and generating income from bond investments. Investors can either accept the fact that yields are low or they can take on more risk and try to seek higher yields. For example, as of November 26, 2019, the Bloomberg USD High-Yield Corporate Bond Index yielded just over 5.75%, while the Bloomberg Barclays US Aggregate Bond Index, which is made up of investment-grade bonds, yielded 2.3%, which is a significant difference. But yield isn't the only story. Lower credit quality increases default risk which can be acute as we approach the end of the economic cycle.

Should investors consider adding high-yield bonds in 2020?

Pariseault: They should understand that the difference in volatility between high-yield and investment-grade bonds is significant. So it's a trade-off. I would advocate for being well-diversified and having a good mix of investment-grade and non-investment-grade bonds according to your willingness to tolerate risk. That will of course be a function of an investor's time horizon and appetite for experiencing volatility.

Short-term Treasurys yielded more than longer-term ones for much of 2019. Is that a recession signal?

Pariseault: The yield curve is no longer inverted (with short-term rates higher than long-term ones), which isn't a surprise. We knew that it wasn't signaling anything more than the fact that we were in the late phase of the economic cycle. The 3-month to 10-year yield curve inverted before the last 7 recessions, which followed 4 to 21 months later, but it also inverted in 1966 and 1998 without a recession afterward. I think fundamentals for the US economy still feel pretty good. Stocks aren't significantly overvalued. Corporations are able to handle their debt because many refinanced it at very low interest rates.

Should the credit quality of high-yield bonds concern investors?

Pariseault: You typically see a deterioration in the credit quality of the issuers of high-yield bonds as you approach late cycle. I think that the same would be true for this cycle, and it could be an issue, but we don't really see it now. The fundamentals seem to be pretty strong. Typically during late cycle is when you start to see increasing distress in a bond index and we just haven't seen it yet.

Presidential candidates are talking about raising taxes and rebuilding infrastructure. Will that help municipal bonds?

Pariseault: I think it's too early to tell. Obviously, some of the proposals out there to raise taxes are favorable towards municipal bonds. I think at this point it's kind of wait and see. The 2017 tax reform was expected to decrease the demand for munis when in fact it actually increased demand and resulted in a pretty strong rally. As for talk about potential infrastructure spending; without anything concrete there's nothing really for the market to sink its teeth into.

How should bond investors be positioned in 2020?

Pariseault: Investors need to have a well-diversified portfolio with a little bit of dry powder in case volatility creates opportunities. It will be important for investors to temper expectations about bond returns and make sure they have high credit quality as we could experience some volatility as we near the end of the current business cycle over the next year or two.

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