Bond opportunities in a strong economy

Consider bank bonds, corporate credit, and inflation-linked Treasury securities.

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Key takeaways

  • The Fed is likely to raise rates again at its September meeting as US economic growth looks poised to continue.
  • The strong US economy is supporting investment opportunities in corporate credit, but careful security selection is important.
  • Bank bonds may offer opportunities as ratings agencies may underestimate the improved creditworthiness of large US banks.
  • Consider inflation-linked Treasury securities as a hedge against rising prices.
  • Caution is warranted on emerging market debt and mortgage-backed securities.

The Federal Reserve left interest rates alone over the summer, but signs of continuing strength in the US economy suggest a rate hike at the Fed's next meeting in mid-September, says Chris Pariseault, CFA®, Fidelity's Head of Fixed Income and Global Asset Allocation Institutional Portfolio Managers. Viewpoints spoke with Pariseault about what Fed policy and the continuing economic expansion means for bond investors and why he sees opportunities in bonds issued by US banks, corporate credit and inflation-linked Treasury securities.

Q: What action do you expect the Fed to take in the coming months?

Pariseault: I expect another rate hike in September and then potentially one more over the following 12 months based on what we know now as the Fed continues to move incrementally. Since December 2015, we've seen 7 interest rate increases of 0.25 basis points, which have brought the target range for the federal funds rate to between 1.75% and 2.00%. This would indicate that we have come a long way already in terms of rate hikes. We are more constructive on the bond market given how far we have come over the past 3 years and see an increased possibility of positive returns.

Q: The Fed's rate policies reflect its leaders' expectations about the direction of future economic growth. Do you expect economic growth to continue?

Pariseault: The US is doing much better than its developed and developing country counterparts, and I think it could continue to do so for a bit. The consensus estimate for 2018 US GDP growth is around 2.8%.

Since the global financial crisis, yields have been low and Fed policy has dominated the bond markets. The US is slowly coming out of that world and entering a more normal environment. There's a debate now on whether the Fed could become too restrictive too soon, especially in light of how much the dollar has strengthened against other currencies.

There also is some concern in the market that this expansion is getting old. It’s been 9 years since the end of the last US recession. If the economy is still growing at the start of next summer, it will be the longest expansion in history. That said, economic expansions don’t die of old age and other economies' expansions have lasted longer than the current one in the US. For instance, Australia's current growth cycle has been going on for 26 years and the UK and Canada had 16-year expansions before the global financial crisis. It will be interesting to see how much longer the US can sustain this expansion. The recent tax and budget packages are likely to help fuel continued economic growth.

Q: What might this long expansion mean for fixed income investors?

Pariseault: The strong economy may make this a good time for investors to explore the credit side of the bond market. Corporate America is fairly strong, fundamentally speaking. That said, the yield on the Bloomberg Barclays US Aggregate index is at its highest level in 10 years and spreads are still fairly tight for corporate and securitized bonds. Even leveraged loans and high-yield bonds are on the expensive side. In this environment, it makes sense to evaluate bonds on an individual basis rather than at a sector level. Picking your names wisely is very important.

Q: Are there certain parts of the market that look particularly attractive?

Pariseault: One area is BBB-rated bank debt. We've seen a lot of debt issued in the BBB market, which now accounts for more than 50% of the US credit market. It's also 4 times the size of the BB-rated market, up from just 2.5 times larger a few years ago.

US financial institutions have issued many BBB-rated bonds. Ratings have been slow to reflect the improving fundamentals of some of these banks. Banks are an extremely strong investment story these days. Systemic risk in the financial sector is very limited and the system is more stable than it has been in the recent past. US money center banks have among the highest levels of common equity capital they've ever had. For larger banks, nonperforming loans are down from a peak of about 4% in 2009 to under 1% today. I would argue that banks are underrated by rating agencies. Ratings will catch up eventually, but for now these bonds still trade a little bit on the cheaper side.

Q: Where else are you seeing opportunities?

Pariseault: I continue to like leveraged loans. They're a bit higher up in the capital structure than high-yield bonds and their shorter maturities and floating rates help them weather a rising rate environment better than their high-yield counterparts.

Q: Are there areas of the bond market investors should be cautious about?

Pariseault: Emerging market debt was a top-performing sector in July, but it was hurt by the recent turmoil in Turkey and Argentina. Now investors can find similar or better values in the US high-yield market without the level of risk that emerging market debt presents. In addition, the Fed's large ownership of mortgage-backed securities still seems to be repressing their yields. I see better opportunities in other fixed income sectors.

Q: Where do you see opportunities in other fixed income sectors?

Pariseault: Investors may want to explore Treasury inflation-protected securities, or TIPS. Although inflation isn't a significant issue today, the TIPS market offers some compelling values and can help hedge a portfolio against the unexpected. TIPS also provide diversification. The Fed has been very clear about sticking to its dual mandate to manage both employment and inflation. We already have low unemployment and inflation is in check, but if wages were to rise significantly, consumption and spending could increase and savings rates could fall. If that happened faster than the Fed moves—or if the Fed doesn’t mind letting the economy run a little hot for a short time—we would see better performance from TIPS.

Q: How can bond investors position their portfolios for higher rates?

Pariseault: These days there are a lot of questions about what to do in a rising-rate environment. It's generally unwise to try to time the market in anticipation of rising rates or movements in credit spreads. In 2009 and 2010, many investors wanted to know what they should do in the face of rising rates but rates didn't start rising in earnest for another 6 years. It's more important for investors to make sure their fixed income portfolios are diversified and appropriate for their time horizons and risk tolerances. Because of the vast size and widely varying credit quality within today's fixed income universe, I believe that experienced active managers can play an important role in helping bond investors achieve their financial goals.

Next steps to consider

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