Bond ideas for today's market

The economy and Fed tightening challenged bonds, but opportunities exist.

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Key takeaways

  • Returns on many bond indexes have been negative this year, as the Fed and inflation worries have moved interest rates higher.
  • The yield curve has flattened, meaning investors are getting less compensation for investing in longer-maturity bonds relative to shorter-maturity bonds.
  • Fund manager Julian Potenza says long-term bonds still have a role to play in a diversified portfolio. But for the more liquidity-focused part of an asset allocation strategy, now may be a good time to consider investment-grade short-duration products.
  • Potenza has been finding opportunities in short-duration corporate bonds issued by relatively resilient, well-run companies with strong balance sheets, improving credit profiles, and fair valuations.

Bond indexes have declined this year, as the growing economy has led the Fed to raise interest rates and investors have grown increasingly concerned about the potential for accelerating inflation.

Viewpoints checked in with Julian Potenza, co-manager of Fidelity Short-Term Bond Fund, for his take on opportunities in this shifting bond-market landscape. Potenza says he's favoring bonds with relatively short durations, focusing on bonds issued by resilient companies, and seeking to capitalize on opportunities presented as the markets adjust to tax reform.

What is your take on the health of the economy?

Potenza: I think the health of the economy supports a continuation of the Fed's plan to tighten monetary policy, though I believe it will be a gradual process. GDP growth cooled a bit in the first quarter from the roughly 3% rate we saw in the second half of 2017, but I still think the US economy is in pretty good shape. I expect that to continue. The labor market is healthy, corporate bottom lines are doing well, and the economy is likely to see additional benefits from tax cuts and increased government spending.

The futures market suggests investors expect 2 more interest rate hikes by the Fed this year. Do you agree with that view?

Potenza: Yes, that feels to me like the right view at this time. The first press conference by Jerome Powell, the new chair of the Federal Reserve, fueled some speculation that the Fed might accelerate the pace of its tightening. But I believe the Fed is going to continue to be relatively patient and keep the pace of tightening fairly gradual. The odds of the Fed going faster than that are somewhat higher than the odds they go slower, because of the potential for fiscal stimulus to provide a boost to an already healthy economy. But I think that chance is still pretty contained.

Do you expect inflation to accelerate this year?

Potenza: Sustained wage growth is necessary for inflation to pick up. In broad terms, we're seeing a slow and steady upward trend in wages, but we’re not seeing the type of acceleration that should be expected when the unemployment rate is around 4%. That said, there are wage and inflationary pressures slowly building in pockets of the labor market. Some companies are having difficulty attracting candidates in industries such as trucking and homebuilding, and in higher-skill roles such as lab technicians and machinists. I also am seeing some wage acceleration at the lower end of the wage spectrum.

Why aren’t wages moving higher?

Potenza: There are a lot of different theories out there, and I don't think there's a consensus answer. I believe one factor is that the specter of automation hanging over a variety of industries limits the ability of workers to bargain for higher wages. For instance, there’s always the potential that a restaurant can replace some of the wait staff with iPads. Another related issue that impacts both wages and inflation: Despite a tight labor market and high consumer confidence, many companies don't feel they can retain market share if they raise prices for consumers. I think technology also plays a role here as so many industries are being disrupted by new upstarts and consumers have so many more tools to comparison shop. Inflation can still pick up from here, but these issues suggest that the risk of a dramatic acceleration is modest.

How is the bond market reacting to this environment?

Potenza: As the Fed continues to tighten monetary policy, the yield curve will likely flatten. That's a continuation of what we've seen in recent years, and a typical pattern when the Fed raises interest rates. There are certainly risks to that view, and I do think that we're likely to see periodic bouts of steepening within that broader trend. In fact, that happened earlier this year: The combination of inflation readings picking up a little bit and expectations for higher US Treasury supply on the back of tax reform led to a steepening of the yield curve. But the curve subsequently flattened as inflation failed to keep moving higher and the Fed continued its slow and steady tightening.

What does the flattening yield curve mean for investors?

Potenza: As the yield curve flattens, investors get less compensation for moving further out on the curve and taking on more duration risk. For long-term investors, long-term bonds still have a role to play in a diversified portfolio. But for the more liquidity-focused part of an asset allocation strategy, now may be a good time for short-duration products.

What has been driving performance within the short-term bond markets?

Potenza: A number of factors hit the short-term markets in the first quarter. We saw an increase in the supply of Treasury bills after lawmakers pushed the debt limit into next year. Meanwhile, the repatriation components of the tax-reform law have led to changes in the funding markets. A lot of the offshore corporate cash that used to invest in the 1-to-3-year part of the credit market has started to be invested in shorter-term securities with maturies in less than 1 year, because that cash can now be deployed. So there's been a period of adjustment in the short-term markets as buyers and sellers adapt to the new rules of the game.

Importantly, I don't see these developments as signs of a wider increase in systemic risk. Instead, I see this as more in line with the money market reforms that occurred in 2016, where rule changes resulted in an adjustment period for investors. As a result, I've been looking at opportunities in commercial paper and among corporate bonds with attractive valuations.

What characteristics are you finding particularly attractive right now?

Potenza: I'm being particularly selective while looking for opportunities amid this period of dislocation. Despite the cyclical strength of the economy, I'm cognizant of some of the longer-term challenges. One is that the current business cycle has been very long, and it’s going to have to end at some point. Another is that while credit spreads have widened recently, they're still fairly tight by historical standards after corporate bonds posted several years of strong performance. What’s more, leverage has increased in some pockets of the corporate market. The result is an increase in fundamental risk.

All that said, I'm looking for bonds issued by relatively resilient, well-run companies with strong balance sheets and improving credit profiles. When I can find names like that at what I consider fair value, that's what I consider to be the sweet spot at this point in the cycle.

Where are you finding those opportunities, and which areas are you avoiding?

Potenza: In the short-term market, one area I have been looking at has been bonds issued by banks. Post-financial crisis, the dramatically changed regulatory environment has led to much stronger bank balance sheets, much higher capital, and much more liquidity than in the past.

There has also been a lot of merger-and-acquisition activity lately. That can present opportunities, but these deals also can go wrong for investors. I tend to be more cautious when I don’t see a company's cash flow supporting the leverage it takes on during an M&A transaction.

As we get further along in the business cycle, I tend to keep the maturities in my corporate bond exposure a little shorter than I would earlier in the cycle. That's one way to earn attractive yields while helping to minimize exposure to a turn in the credit cycle and a period of spread widening.

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