During the volatile third quarter of 2011, markets were rattled by the debt crisis in Europe and the contentious debt ceiling debate in the United States. Since then, higher-yielding credit sectors globally have rallied as the U.S. labor market has healed and recent long-term refinancing initiatives have improved liquidity conditions in the eurozone.
With the recent gains, return expectations in fixed income over the near term appear modest, but longer-term investment opportunities in that sector can still be found in the following areas:
High yield. The yield spread between high-yield bonds and U.S. Treasuries has tightened, with absolute yields low by historical standards. Caution is warranted in the near term, given myriad global risks, but as the U.S. economy continues to heal, value will re-emerge. High-yield new-issue volume remains robust. Defaults are expected to remain low if the economic recovery progresses as expected, even if growth remains modest. Floating-rate bank loans in particular could perform well, especially if interest rates rise.
Investment-grade corporate bonds. Corporate credit risk appears to be in better shape at this time, as low rates have allowed firms to refinance debt and repair balance sheets. A specific challenge is secondary-market liquidity, which can be stretched in times of market stress. The triple-B segment of investment-grade corporates continues to look attractive on a relative basis, and valuations for the industrial sector are appealing relative to financials and utilities, particularly after the strong rally in financials in the first quarter.
Emerging markets. An evolving theme is the convergence in credit quality between emerging- and developed-markets debt. Valuations of developed-markets bonds appear rich, but selective local-currency bonds, which tend to have higher real yields than developed-markets debt, also offer value. Brazil and Mexico could yield strong returns despite risks. Dollar-denominated emerging-markets debt — particularly the rapidly growing emerging-markets corporate-bond sector — also offers opportunities, though in a consistent theme across credit markets, valuations appear less attractive, given this sector's recent rally.
Mortgage-backed debt. The value of liquidity can't be underestimated in today's credit markets. Agency mortgage-backed securities are one of the few areas with good liquidity. Head winds to MBS include tight spreads, government initiatives to stimulate the beleaguered housing market (which would increase MBS' prepayments), and a decreased likelihood of further quantitative easing by the Federal Reserve through the purchase of mortgage-backed securities. A key risk in MBS is a spike in interest rate volatility. But if Treasury yields remain range-bound over the near term, these securities' yield premiums will offer an attractive, liquid alternative to Treasuries.
Currencies. The dollar benefited last year, particularly in the third quarter, from its “safe haven” status. In the absence of an unexpected risk event or increased European sovereign stress, which could provoke dollar strength, we see value in currencies backed by solid current account positions and strong economic prospects — including currencies from emerging economies in Asia and elsewhere.
Interest rates. Longer-term Treasury yields remain near historical lows, driven by quantitative easing and slow to modest economic growth. This could continue over the near term, with continued modest-growth expectations and global risks that include sovereign concerns in the eurozone, and the strength of the recovery and unresolved fiscal issues here in the United States. However, as the economy recovers and the Fed prepares to exit from monetary accommodation, Treasury yields could very well increase. Such moves can happen quickly, so it is preferable to keep bond durations slightly short.
Risks and uncertainty argue for a balanced fixed-income approach. Although the investment environment has markedly improved in recent months, risks remain: rising oil prices, continuing fiscal challenges domestically and in Europe, and weaker growth in key emerging markets such as Brazil and China.
This uncertainty suggests a diversified approach that balances liquidity and credit exposure. On the credit side, that means higher-yielding credit and emerging-markets sectors that can provide longer-term value, and for liquidity, that means exposure to mortgage-backed securities and higher-quality sovereign debt.
Steven Huber, a vice president at T. Rowe Price Group Inc., leads the portfolio strategy team within the firm's fixed-income division and is portfolio manager of the T. Rowe Price Strategic Income Fund.
