2010 fixed income outlook
Commenting on the outlook for markets in 2010, Andrew Wells, CIO of Fixed Income at Fidelity International, says: "As investors look towards 2010, three themes are likely to dominate the fixed income investment landscape.
1 The hunt for yield continues;
2 There is enormous uncertainty about the timing and nature of unwinding policy stimulus such as quantitative easing and low cash rates; and
3 The potential for rising inflation to erode fixed income returns.
1 The hunt for yield continues
"For investors in search of yield, investment grade corporate bonds are likely to remain the key focus. While yields have fallen from their peaks of March this year, yields remain attractive versus cash and government bond alternatives. Indeed, credit spreads continue to offer ample compensation for default and downgrade risks and are still wide relative to history. The attractive value still on offer means that enthusiasm towards corporate bonds is likely to stay in check. Meanwhile, as cash rates stay low and uncertainty about the economy stays elevated, I expect flows into corporate bonds will continue.
"Moving out the risk spectrum and into high yield may also continue attracting investors in search of income. With double digit yields still on offer, there is still value in the high yield asset class but managers will need to rely less on market direction to drive performance. In particular, name selection will be critical as defaults stay elevated. Importantly, mixing investment grade corporate bonds with a portfolio of high yield can offer a very attractive income generator with low volatility as the two asset classes each interact differently against economic and market variables.
2 Preparing for the end of monetary easing
"For investors concerned about the impact of rising cash rates, allowing managers more flexibility to extract value from across fixed income markets may be an important focus for 2010. To this end, strategic bonds funds may be suitable, including those with the ability to hold an efficient mix of government bonds, investment grade credit, high yield, international bonds and inflation linked assets. As interest rates rise, having the right mix of assets may deliver better returns than traditional investment grade credit funds without unduly adding risk in a portfolio.
"Reducing fund duration to better protect an investment portfolio is also likely to be a hotly debated topic next year. However, investors should consider the subtle risks of such an approach. The steep yield curve means it currently pays handsomely to hold longer maturity assets over cash. This means hedging duration can have a sacrifice on yield. Meanwhile, duration offers investors powerful equity diversification benefits as it is the only true source of protection against a sell-off in risky assets and any renewed deflationary concern. Reducing a fund's duration can therefore leave it highly correlated to equity and vulnerable to an equity market sell-off.
3 Protecting against inflation uncertainty
"Inflation presents the biggest risk to fixed income markets in 2010 although there are many pockets of the bond universe that can do well if inflation increases. The inflation linked bond market is likely to grow in importance as investors seek protection against policy mistakes. However, if inflation pressures re-ignite, it is likely to be a global phenomenon with synchronicity of performance of inflation linked bonds globally. Therefore, to best protect against inflation, investors should look beyond local markets to isolate the cheapest possible protection. For example, countries such as Japan and the US may offer better value than European inflation linked markets, even after currency hedging.
"Another asset class that can also do well in inflationary periods is high yield. For highly leveraged companies the ability to repay debt can improve as prices rise and I'd expect to see further spread narrowing if inflation rises. Therefore inflation linked bonds can be considered as providing a degree of inflation protection for a diversified fixed income portfolio.
Diversification will be key
"The above three themes highlight the importance of diversification in 2010 and after a strong credit market recovery in 2009, investors must now think harder about the sources of returns from their fixed income investments.
"After strong performance across our key funds in 2009, our managers are looking far and wide for sources of return. Indeed, directional strategies are likely to be less important next year with renewed focus on cross market interest rate strategies, sector tilts and name selection. Importantly, now is not the time to let top-down strategies dictate an investment portfolio and it is important for managers and investors to diversify not only at the bond level, but also in terms of strategy and asset mix."