Biggest fund managers describe their best bond market bets
Some see steepening yield curve, others like emerging markets
It turns out 2017 was a good year to be a bond investor — if you picked the right spots. Next year presents plenty of potential pitfalls, from divining the path of inflation to determining whether tight credit spreads can persist.
Bloomberg has drawn together views from money managers who oversee a combined total of more than $7 trillion in fixed-income assets for their perspectives on how to achieve top returns in the year ahead. Some urge caution, although many acknowledge that the global economy looks to be on solid footing.
Here’s a summary of their investment outlooks:
BlackRock Inc., which oversees $1.78 trillion in fixed income, favors moving up in credit quality, according to its 2018 global outlook. Buying illiquid debt during a rally when everyone wants it may seem safe, but in a selloff, volatility will spike as the exits get crowded.
“Everyone can take home a trophy when ostensibly low risk is rewarded handsomely. This has played out in global credit markets,” wrote strategists including Jeff Rosenberg. “But the risk inherent in these strategies rises disproportionately as credit spreads narrow.”
The world’s largest money manager doesn’t have any overweight recommendations in the fixed-income section of its 2018 outlook. The firm has a neutral stance on U.S. municipal bonds, U.S. credit, emerging markets and Asian fixed income, and an underweight position on Treasuries, European sovereign debt and European corporate bonds.
Rick Rieder, BlackRock’s global chief investment officer for fixed income, has said he likes the front end of the Treasury curve, with two-year U.S. yields around their highest level since 2008.
Inflation is finally going to accelerate in 2018, and you’d do well to have Treasury Inflation Protected Securities to guard against it, said Ford O’Neil at Fidelity, which has $975 billion in fixed-income assets. He and his team won Morningstar Inc.’s 2016 fixed-income fund manager of the year award for overseeing the Fidelity Total Bond Fund.
O’Neil’s primary goal is preserving gains of the last two years. He said that he likes owning leveraged loans (as he did to start 2017), given that their interest rates reset higher with Federal Reserve hikes.
Brazil and Mexico are O’Neil’s favorite emerging-market countries. Short- and intermediate-term debt from “national champion” banks in large European countries also look good.
Goldman Sachs Asset Management
“Our highest conviction view is around a reintroduction of volatility,” said Mike Swell, co-head of global fixed-income portfolio management at Goldman Sachs Asset Management, which looks after about $500 billion in active fixed-income.
Swell said in an interview that he expects inflation will surprise higher, leading the U.S. yield curve to steepen — in contrast to the relentless trend in the final months of 2017. He’s going short duration and buying steepeners to profit from his outlook.
GSAM suggests owning less corporate credit than usual. The same goes for agency mortgages, which the Fed is shedding as part of its balance sheet normalization process.
“The potential for credit widening in 2018 is something that’s not really being discussed a lot, but should be on people’s radar,” Swell said.
He likes emerging market debt: specific countries include Hungary, Poland, the Czech Republic, Mexico, Brazil and Colombia. He’s avoiding currencies that have significant exposure to China.
JPMorgan Asset Management
“Europe just looks healthy,” said Bob Michele, who oversees $483 billion as head of global fixed income, currency and commodities at JPMorgan Asset Management.
For that reason, he’s buying European additional tier-1 securities and high-yield debt. When hedged back to dollars, the bonds yield about 5 percent.
The biggest risk “is that inflation picks up, the Fed does four hikes, not three, and without QE suddenly you get some steepening of the curve,” Michele said in an interview. He expects that to play out.
Under that scenario, short-term rates could rise 75 to 100 basis points, while the long end jumps 100 to 125 basis points.
Michele hedges away much of the interest-rate risk in his portfolio with futures. Credit spreads, though they’ve tightened, still have room to absorb broad interest-rate increases, in his view.
What doesn’t he like? Anything the European Central Bank bought.
Emerging markets, on the other hand, are a winner — Indonesia, Brazil and Russia in particular. “Between those, you get a yield of about 8 percent, and that looks very cheap relative to the developed markets,” Michele said.
Pacific Investment Management Co.
Pimco, which oversees $1.7 trillion, also says a leading risk is rising U.S. inflation. The money manager expects at least three Fed rate hikes.
Markets are at or near the peak of the current cycle, and investors should become defensive before they turn down. Dan Ivascyn, Pimco group chief investment officer, is calling for underweight positions on duration and low-rated corporate securities.
He said in an interview that markets have probably front-loaded the benefits of U.S. tax changes and fully priced assets are setting the stage for uncertainty in 2018.
“When valuations are full, small amounts of bad news or new news hitting the market can have a greater impact on volatility,” Ivascyn said. “We’re at a point now where you have much less margin for error.”
Pimco is also betting on a steeper U.S. yield curve. The Fed’s shrinking balance sheet, greater government deficits and less monetary stimulus abroad mean investors will demand a higher premium on longer-term debt.
Tad Rivelle at TCW says investors should take the opportunity now to insure against an eventual downturn, even as the economy seems to be hitting its stride. Years of central bank intervention have distorted interest rates and asset prices.
“When the correction comes, it could come in a more severe package,” said Rivelle, whose firm has $179 billion in fixed-income assets.
Fixed-income investors should be content in 2018 with safe returns of 2.5 percent to 3.5 percent rather than reaching for risk. Such gains could come from a mix of high-quality corporate bonds and commercial real estate, along with agency mortgages.
A flattening U.S. yield curve could be “public enemy No. 1” for investors, Rivelle said in an interview. The trend is likely to continue if the Fed sticks to its path and raises rates three times next year. Higher short-term rates may erode the credit quality of some companies with high leverage, he said.
The flattening yield curve trend in 2017 represented a “regime change” from the past several years, according to Anne Mathias, senior strategist at Vanguard, which oversees $1.3 trillion of fixed-income assets. Shorter-term Treasuries saw the biggest moves, while the long end remained anchored in a range. Expect that to continue in 2018.
“There are more tactical opportunities in the short end and there’s good, decent long-term stability and yield pickup in the longer end,” she said in an interview.
She’s also watching the cross-currency basis swap market to gauge demand for U.S. bonds from Japan and Europe. Earlier this month, the hedged yield on 10-year Treasuries fell to a record low.
Western Asset Management
The fund manager with $367 billion in long-term fixed-income assets says 2018 will be a lot like 2017. That means stubbornly low inflation and bonds with some added risk — like corporate, emerging market and structured debt — delivering higher returns.
“We’re still optimistic on a lot of the spread sectors,” Western Asset Management Deputy Chief Investment Officer Michael Buchanan said in a telephone interview.
Central banks may not be able to normalize policy as fast as they want because of modest inflation, Buchanan said.
Winning bets include emerging-market local currency debt because of high nominal rates. Also what Buchanan calls “rising star trades,” or bonds likely to receive credit upgrades, since they can add 40 basis points to 70 basis points of spread compression.