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  • July 23, 2013

    After several years of outstanding returns, bond markets dropped this spring as interest rates surged from historic lows. Almost all bond sectors turned in negative returns during the second quarter of 2013. Steve Huber, Strategic Income Fund portfolio manager, discusses what's changed and how fixed income investors can navigate uncertainty.

    Fed: Quantitative Easing May Taper by Year-End

    Markets reacted dramatically to comments by Federal Reserve Chairman Ben Bernanke that the Fed might begin tapering off its stimulative efforts by year-end, and interest rates rose as much as a full point worldwide. However, Huber reminds investors that this was actually good news, since it means there has been fundamental improvement in the economy. The Fed has indicated that it will take action based primarily on unemployment levels, so backing off would mean that labor markets were improving. Nonetheless, bond markets are likely to be somewhat volatile until an actual start date for tapering is announced. While this will likely generate some volatility, it also could create investment opportunities.

    Liquidity Offers Flexibility in a Stressed Environment

    Liquidity in fixed income markets has been a concern since the beginning of the financial crisis. With investors streaming out of bond markets, liquidity remains a concern. Huber says managers need to take care to maintain ample liquidity in current conditions, making it easier to shift assets and take advantage of opportunities to invest in undervalued sectors. For their part, investors should make moves gradually, Huber cautions. And investors should maintain a place in their portfolios for Treasuries. Treasury yields have risen, providing better current income, and they can play an important role in a diversified bond portfolio, providing safety and liquidity.

    Diversify to Navigate Uncertain Markets

    The bull market of recent years for bonds appears to be coming to a close. According to Huber, the double-digit gains of investment-grade and high yield bonds are unlikely to return. In the long term, as yields rise, fixed income will become more attractive again, but Huber anticipates low and possibly negative returns in the interim. This will be especially true in Treasuries and sectors with longer durations (a measure of a bond price's sensitivity to changes in interest rates), such as investment-grade corporates. High yield issues will likely outperform Treasuries as the economy continues to improve, but there is still a great deal of risk in the global economy, so investors should not be too concentrated in it or any other sector. In this setting, diversifying your fixed income portfolio is key, because performance among sectors is likely to be more disparate than it has been in recent years.

    The views are as of July 2, 2013 and may have changed since that time. This information is provided for informational purposes only and is not intended to reflect a current or past recommendation, or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

    Stocks and sectors may not perform in line with the manager's expectations. All funds are subject to market risk, including possible loss of principal. Bonds are subject to credit risk and interest rate risk. High yield bonds and floating rate (or "leveraged") loans have a greater risk of default than higher quality bonds. In addition, floating rate loans are usually considered speculative. Investors should note that if interest rates rise significantly from current levels, bond returns are likely to decline. Some income from municipal bonds may be subject to state and local taxes and the federal alternative minimum tax. Diversification cannot assure a profit or protect against loss in a declining market.

    Copyright 2014, T. Rowe Price Investment Services, Inc., Distributor. All rights reserved.