Where Are Income Opportunities?

November 23, 2011

Steve Huber, the head of T. Rowe Price's fixed income strategy team and the manager of a T. Rowe Price global fixed income strategy, is finding income opportunities despite the volatility and low-rate environment.

• We have endured a fairly long period of heightened volatility and historically low yields on fixed income investments.
• The real yield—the yield after allowing for inflation—on Treasuries out to about 10-year maturities is negative, which prompts us to look in other areas in an effort to generate better returns.

• Fundamentally, the high yield market is attractive based on the low default rate and the broad strength of corporate balance sheets.
• Many high yield issuers have improved their liquidity profile, extended maturities on their debt, and refinanced into lower-coupon bonds.
• Defaults in the asset class are likely to be lower than those implied by the current yield, which is in the 8% to 9% range for the JPMorgan High Yield Index.
• One of the areas that can provide a hedge against rising rates is bank loans, also known as floating rate bonds. Floating rate loans are usually considered speculative and involve a greater risk of default than higher-rated bonds.

• We are positive on the prospects for emerging market corporate bonds, which are largely rated investment grade.
• Emerging market economies have fewer headwinds than developed markets that face budget cuts and austerity measures.
• Nondollar-denominated emerging market bonds provide positive real yields and could benefit from the long-term expected decline of the U.S. dollar.

• There are clearly risks in high yield and emerging market bond investing, but we like the risk/reward trade-off. Fundamental credit research remains a critical part of our security selection process.
• When investing in higher-yielding securities, one of the major risks is economic deterioration. We think the global economy will continue to generate slow growth and that the U.S. economy will not dip into recession.
• We have recently looked to balance our higher-risk exposures by diversifying other holdings in safer and more liquid sectors, such as agency mortgage-backed securities.

• Bond markets at home and abroad have been driven by political and policy events in Europe, but we do not think we will see a global credit crisis on par with 2008.
• We are in a slow growth environment, and Europe clearly faces the biggest challenges—it may already be in recession.
• When we look at the global economy, the U.S. is doing pretty well and will likely avoid a recession. We also think that the Chinese economy will slow but not endure a "hard landing." Volatility provides the opportunity to tactically build positions.

• The largest risk in owning U.S. Treasuries is higher interest rates. It is likely that over the longer term, developed markets will begin instituting rate increases.
• If rates rise sharply, investors can lose money in Treasuries because interest rates and bond prices generally move inversely.

Bond yields and share prices will vary with interest rate changes. Investors should note that if interest rates rise significantly from current levels, bond fund total returns will decline and may even turn negative in the short term.

Unlike traditional fixed income bonds, the market for floating rate loans is largely unregulated and the loans do not trade on an organized exchange, making them relatively illiquid and difficult to value. The underlying loans are subject to significant credit, valuation, and liquidity risk. The loans and debt securities are generally considered speculative.

High-yield bonds carry greater default risk than higher-rated bonds along with greater liquidity risk. Investments in foreign bonds are subject to special risks, including potentially adverse political and economic developments overseas, greater volatility, lower liquidity, and the possibility that foreign currencies will decline against the dollar. Investments in emerging markets are subject to the risk of abrupt and severe price declines.

Diversification does not assure a profit or protect against a loss in declining markets.

The information presented was current as of November 27, 2011. The managers' views and the funds' portfolios may have changed since that time. This material should not be deemed a recommendation to buy or sell shares of any of the securities discussed. Stocks and sectors may not perform in line with the manager's expectations. All portfolios are subject to market risk, including possible loss of principal. Fixed-income investing is subject to currency risk and interest rate risk, and high yield bonds have a greater risk of default than higher quality bonds. Investors should note that if interest rates rise significantly from current levels, bond fund total returns are likely to decline and may even turn negative in the short term.