What should bond investors do in 2019?

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

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Key takeaways

  • The Fed may stop raising interest rates in 2019.
  • The end of rate hikes may create more opportunities for investors.
  • Bonds issued by banks, REITs, and insurance companies may present opportunities while energy and consumer cyclical bonds may deserve caution.
  • An inverted yield curve makes headlines but is not cause for excessive concern.
 

As 2018 draws to a close, volatile markets are making headlines. The questions for bond investors are whether these events increase the chances that the Federal Reserve will stop raising interest rates and whether an economic downturn is near. With this in mind, Viewpoints spoke with Chris Pariseault, CFA©, Fidelity's Head of Fixed Income and Global Asset Allocation Institutional Portfolio Managers, about what he expects from the economy and the bond markets in 2019, where to look for opportunities—and where to be cautious.

In early December, the big news in the bond market was that the yield on 5-year Treasuries fell below yields on 2- and 3-year Treasuries. An inverted yield curve always makes headlines, but how big a deal is this inversion?

Pariseault: Not very big. The difference between 3- and 5-year Treasuries was very small—only about eight-tenths of a basis point. In my mind, it's not much of an issue. Even though we're approaching the late part of the economic cycle, the US is still experiencing significant real GDP growth of about 3.5%. An inverted yield curve sometimes signals a recession, but we don't see anything else that conclusively shows we're heading toward a recession. It would be a bigger issue if yields on 10-year Treasuries fell below those on 2-year Treasuries. That hasn't happened. At this point, we don't see the inverted curve as something investors should worry about.

Do you expect the Federal Reserve to further raise rates in 2019?

Pariseault: In late November, Fed Chairman Jerome Powell sort of walked back his hawkish comments from October and suggested that the Fed is close to being done raising interest rates. The terminal federal funds rate can't get much higher than where GDP growth is likely to be. GDP growth rates and 10-year Treasury yields and GDP growth rates tend to be approximately the same and that correlation has been pretty consistent over time. So with GDP growth around 3.5% and 10-year Treasury yields around 3%, it's reasonable to expect that the Fed won't make too many more interest rate moves.

How should bond investors be positioned for 2019?

Pariseault: We think it makes sense to keep some powder dry to take advantage of opportunities. If we’re nearing the end of the rate hike cycle, yields are going to start looking more attractive given the expected leveling off in yield increases. If we are indeed approaching the end of rate hikes with credit spreads a bit wider, greater opportunities for positive returns may exist in 2019.

However, we seem to be nearing the late stages of the economic cycle. History shows these stages can last a long time—as long as 18 months. In this environment, investors should consider upgrading the credit quality of their portfolios. With higher interest rates, fixed income is likely to produce more positive returns.

If credit quality starts to deteriorate and evidence increases that we're entering an economic late-cycle—or potentially a recession—that could mean poor returns for riskier sectors of the market. At this point, however, we haven't seen compelling evidence that is about to happen.

What would be a sign that credit quality is deteriorating?

Pariseault: Take the leveraged loan market as an example. These securities are issued by companies with high levels of debt and they often feature relatively low credit ratings. When demand for these assets is high as it is now, issuers can get away with looser covenants (provisions that help to protect investors). A sign of distress would occur if more issuers became unable to meet the terms of their covenants. Late in the economic cycle, issuers can face slowing growth, tighter credit, and pressure on earnings. Investors who hold leveraged loans with looser covenants are at greater risk when conditions deteriorate. This has not happened yet but we are watching for indicators.

On the credit side, do investment-grade bonds or high-yield bonds look more appealing?

Pariseault: Both sectors look relatively attractive and we are selectively adding both. Investment-grade credit spreads were 130 basis points in early December which is in the middle-to-high end of their 10-year range.

What investment-grade sectors look appealing?

Pariseault: We continue to like the financial sector because banks' balance sheets remain strong and higher rates are boosting their net interest margins. Real estate investment trusts (REITs) also have some appeal. REITs generally produce decent income streams, and they tend to have strong covenants that help protect investors. REIT bonds fared relatively well during the global financial crisis by being capital-aware and maintaining good balances between equity and debt. And the insurance sector also looks attractive as we head into 2019. Insurance companies have benefited from higher interest rates earned from annuity and life insurance products, capturing more of the spread between what they pay out and what they earn on the underyling investments.

What sectors should investors approach with caution?

Pariseault: Energy is one sector we're keeping our eyes on. We don't necessarily think it's in trouble, but it's hard to ignore the fact that oil is down sharply over the last 6 weeks. In early December, oil was selling at $50.93 a barrel, down 15% year-to-date. That's a sector that can be volatile for bond investors. We also think some industrials, technology, and some of the consumer cyclical sectors could suffer in the event of an economic downturn.

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