A good time to diversify with fixed income

Bond markets offer opportunities to position portfolios for the long term.

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Key takeaways

  • Current market conditions offer investors an opportunity to add yield and diversify their portfolios ahead of an eventual economic slowdown.
  • The Federal Reserve will likely take a wait-and-see approach to further interest rate hikes as inflation stays low.
  • The volatile markets at the end of 2018 have created opportunities in investment-grade corporate bonds.
 

The market volatility at the end of 2018 may be fading from investors’ memories. But before it's forgotten, perhaps it should prompt them to consider whether their portfolios are adequately diversified and properly positioned for future volatility and a potential economic slowdown.

Fortunately, says Chris Pariseault, CFA©, Fidelity's Head of Fixed Income and Global Asset Allocation Institutional Portfolio Managers, today's bond markets provide a variety of opportunities for investors looking to diversify their holdings. We spoke with him recently about finding those opportunities—and where to be cautious.

At the end of 2018, equity markets turned volatile and prices for many bonds also dropped, which may not be what many investors expected. Now, market conditions seem much like they were before the correction. Is there a lesson here for fixed income investors?

Pariseault: The volatility in the fourth quarter of 2018 rewarded fixed income investors who invested in higher-quality bonds and risk-free assets such as US Treasury bonds. It also provided a reminder of how important it is to keep portfolios diversified in uncertain times.

What is causing the Federal Reserve so far this year to take a break from its recent push to raise interest rates?

Pariseault: The Fed recognized that US financial conditions, whether for home mortgages or company bank lines of credit, had tightened too much too quickly, especially with inflation running at below the Fed's target rate of 2%. Global economic conditions are slowing as well with weakness in the eurozone, China, and other parts of the world. We are somewhat encouraged by trade news and note that earnings for the S&P 500 have been revised upwards for 2019, albeit only slightly. Oil prices have also rebounded, the dollar has stabilized, and credit markets now have more value following the events of the fourth quarter of 2018.

When do you expect the Fed to further raise rates?

Pariseault: We think it's possible that this hiking cycle has ended and that any further moves will be episodic, either upward or downward. The market is not pricing in much of a move in 2019. This seems appropriate given that inflation is contained and global growth is weakening. GDP growth rates and 10-year Treasury yields tend to be highly correlated and that correlation has been pretty consistent over time. So even if US GDP growth hits 3.5%, which might be the high end, 10-year Treasury yields are fairly priced at current levels.

What does that slowdown in global growth and also in the pace of tightening by the Fed mean for bond investors?

Pariseault: Investors should always start with an investment mix based on their time horizon, financial situation, goals, and risk tolerance—and should stay diversified in their asset allocation.

Most investors could benefit from a diversified mix of investment-grade corporate bonds and risk-free assets such as Treasurys, depending on their time horizon and overall risk tolerance. Fortunately, many parts of the fixed income market now present opportunities, so diversifying one’s portfolio and adding yield is easier than it might be otherwise. In fact, yields are much more attractive across the board than they were a year ago.

Where do you see opportunities for investors to diversify their portfolios by investing in fixed income?

Pariseault: Investment-grade corporate bonds look attractive right now. In December, spreads had widened to a point that was not in line with expectations of defaults. Default expectations have ticked up a little, but not enough to justify the widening of spreads that had taken place. As a result, we see opportunities in the credit markets where things have cheapened up nicely. Munis look fairly attractive in terms of credit quality. The supply of short-duration munis is somewhat limited, but they are still attractive for investors who seek tax-advantaged income.

That’s a pretty positive investment landscape. Is there anything lurking out there to be concerned about?

Pariseault: A fairly benign but low growth environment will pressure some sectors of the global economy. We’re not calling for a US recession, but some sectors of the economy will feel the pinch of lower growth and revenues. Diversification will be very useful for investors, leaving room for what we believe will be opportunistic asset allocation.

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