April 23, 2014
|Steve Huber, portfolio manager of the T. Rowe Strategic Income Fund.|
Bonds had their worst year in recent memory last year, with most sectors recording losses. Performance has rebounded in early 2014, but investors remain on guard as the Federal Reserve pulls back on the stimulus that has helped suppress bond yields. Steve Huber, who has managed the Strategic Income Fund, a global multi-sector portfolio, since its launch in December 2008, discusses his outlook for global interest rates, sectors, and currencies.
Q. Weak performance in 2013 led to much speculation that this marked the end of the more than 30-year bull market for bonds. Is that valid?
A. That's probably right, because interest rates were at extremely low levels that seemed unjustifiable longer term. Our view is that rates will continue to go up, but it will happen in fits and starts—not a straight line. If we see better employment numbers over the next few months, as we expect, interest rates should continue trending higher. However, I don't see a repeat of last year in terms of the magnitude of rate increases.
Longer-term rates have priced in the Federal Reserve tapering its bond purchases. From here, economic data—and, from time to time, risk aversion—will determine the direction of rates. Late in the year, short-term rates should begin to rise as the market prices in an eventual fed funds rate increase, which could happen later in 2015 or 2016.
It makes sense to diversify globally, not only because rates in the United States are still low and could go higher, but also because there are opportunities in non-U.S. markets that offer investors higher real [inflation-adjusted] yields.
We are keeping duration* in the portfolio relatively short, primarily in the United States but also in other developed markets. [*Duration measures a bond's sensitivity to interest rate changes. Bonds with longer durations tend to see greater price declines if rates rise and greater price gains if rates fall.]
The United States and the United Kingdom are at the forefront of the tightening cycle for developed markets and could see rates go up sooner. The eurozone looks like it will remain weak, but yields are low and likely to trend upward as the economy heals. Yields in Japan are also very low given their continued monetary stimulus. The fund maintains some duration in the emerging markets, where investors can get higher yields, both nominal and real.
Q. With your leeway to invest in a variety of sectors, which ones look most attractive right now?
A. It's more difficult to find value in credit sectors than it has been over the past few years because yield spreads* are tighter across credit markets. [See chart below.] We are in an environment where the downside risk seems more limited, but the upside potential does also. [*Spreads refers to the additional yield that riskier bonds offer over U.S. Treasuries of comparable maturity.]
We have been running underweight in investment-grade corporate bonds. The sector should do well as long as rates stay low, but spreads are tight. And with longer durations, the sector may be more at risk should rates go up. We are also cautious on mortgage-backed securities due to valuations. With the Fed tapering and eventually ending its mortgage purchases, there is going to be less support for the sector.
Because of their higher yields and lower durations, high yield corporate bonds should do better than their investment-grade counterparts if our outlook for continued economic recovery holds.
However, the sector's total returns are likely to be more subdued than last year's. We could see modest price appreciation, but investors are more likely to realize a return that closely approximates the yield on their investments. Bank loans, with their floating rate feature and minimal duration, are also still fairly attractive.
In emerging markets, there are a number of risks: slower growth, inflation pressures, and upcoming elections in a number of countries, which make officials hesitant to take on some of the harder policy decisions. But valuations look more attractive when viewed over a longer-term horizon. Specifically, we have started to add exposure to dollar-denominated emerging market sovereign bonds. The market is largely investment grade, and spread levels appear attractive versus U.S. investment-grade bonds.
Bond Investors Getting Less Reward for Risk
Over the last seven years, the additional yields of corporate bonds and emerging market sovereign bonds above the yields offered by U.S. Treasuries have risen sharply and then fallen, meaning investors now are being compensated less for credit quality risk.
*A basis point equals 1/100th of one percentage point. Indices used are the Barclays U.S. Corporate Investment Grade Bond Index, J.P. Morgan Global High Yield Index, and J.P. Morgan Emerging Markets Bond Index Global.
Sources: Barclays, J.P. Morgan, and T. Rowe Price.
Q. These higher-yielding sectors can be more volatile than traditional, high-quality sectors. How are you managing these risks?
A. Although we have exposure to sectors with higher-risk/higher-return potential, we also keep some liquidity in the portfolio via government and government-related sectors. Volatility has been low across markets, but we expect it to increase as we navigate through global growth concerns and emerging markets work out their issues. So we want to have ample liquidity to reinvest in those sectors should volatile events lead to lower prices and more attractive valuations.
Our goal is to keep an eye on downside risk and avoid too much exposure to any one sector. [See chart below.] We aim to increase risk only when we think we're getting paid to take it. We want to be able to nimbly exit sectors when valuations are less compelling and raise liquidity when valuations do not justify taking risks.
The main risks currently center on global growth. In the United States, the risk is that recent labor market weakness persists or the housing recovery unexpectedly stalls. Globally, the eurozone and Japan are earlier in the recovery cycle and staying with easier monetary policy. With the developed markets at different points of recovery, the real risks are now more concentrated in emerging markets.
Getting the timing right on emerging markets will be crucial in capturing returns while avoiding pitfalls. Growth in China will be a key indicator for the performance of emerging markets. It is often seen as a bellwether for other emerging economies, and the extent of a potential slowdown has taken on greater importance.
There also are risks in the policy decisions of emerging countries, most notably the "fragile five"—India, Indonesia, Turkey, Brazil, and South Africa—which have upcoming elections. And the recent events in Ukraine are a reminder of periodic geopolitical risk, where the question is whether it will be contained or spill over to other markets.
Looking Beyond Traditional Fixed Income Sectors
The Strategic Income Fund ranges widely among global bond sectors in search of the right combination of risk and return. As of March 31, 2014, more than half of the Strategic Income Fund was invested in bond sectors that are not represented in the Barclays U.S. Aggregate Bond Index, a common benchmark for domestic bond funds. In a rising rate environment, many of these sectors are typically less sensitive to U.S. interest rate changes than high-quality U.S. bonds. This chart compares the fund's sector allocations against those of the index.
|Sector||Strategic Income Fund||Barclays U.S. Aggregate Bond Index|
|U.S. Mortgage-Backed Securities||10.3||29.2|
|U.S. Investment-Grade Corporates||8.2||23.0|
|Commercial Mortgage-Backed Securities||2.3||1.7|
|Emerging Markets (Local Currency)||15.0|
|Emerging Markets (USD)||14.9|
*Totals exceed 100.0% because of rounding of sector data.
Sources: Barclays and T. Rowe Price.
Q. Currencies have been quite volatile in recent months, particularly those from emerging markets. Are they still an area of opportunity?
A. You used to hear a lot about emerging markets decoupling from developed markets because their growth was stronger. Now it has flipped, and the concern is growth in the emerging markets. This has been most evident on the currency side, with currencies taking the brunt of the concerns around the prospects for emerging economies.
We could see continued dollar strength, especially as we get closer to Fed tightening. But emerging currencies have cheapened enough to warrant attention from investors with a longer-term horizon.
One of the currencies we have been focused on is the Mexican peso. Mexico has made important economic reforms, and the country is more tied to the U.S. economy than most other markets.
On the riskier side, we have grown more positive on countries like Brazil that have higher yields than Mexico but are also challenged by slower growth and stubborn inflation. Brazil has been forced to hike rates to deal with inflation, and more will probably need to be done. Despite these challenges, valuations look more attractive than they did a few months ago.
Local currency emerging market bonds are a longer-term play, and we expect to see continued volatility in the near term. But as countries get past elections, further progress toward fiscal and monetary policy reforms—if done the right way—could put in place the foundation for long-term growth.
Q. Fixed income has traditionally been regarded as a valuable source of diversification in a balanced portfolio. With today's low yields, is that still the case?
A. Yes, diversification is important, and bonds are still a large part of that. The big concern that we hear from investors is the degree to which rates are going to increase. We have seen a fairly large increase already. That will moderate somewhat unless we see unexpected inflation pressures or a much stronger recovery than we are anticipating, thereby moving up the timing of Fed rate hikes.
Historically, there haven't been as many opportunities globally, but fixed income markets are now more global. It is a way to diversify the portfolio, spread around some of the risk, and potentially enhance returns.
The latitude to invest across a variety of regions and return sources—which can take the form of credit sectors, duration, currencies, or traditional security selection—is an important component of our process.
In environments where there are few opportunities in one part of the world, there may be opportunities elsewhere. And if there are not opportunities in credit sectors, you can always increase exposure to interest rate moves or currencies.
Diversification cannot assure a profit or protect against loss in a declining market. Yields can vary with interest rate changes, and certain holdings are subject to credit risk. International investing, particularly in emerging markets, entails additional risks, including currency risk.