LOOKING FOR RETURN
In the past—before the rise of the global economy and the acute fiscal challenges currently facing governments in developed markets—investors were able to rely on a mix of investment-grade bond funds that included U.S. government-backed securities, Treasuries, and investment-grade corporate bonds to anchor their portfolios. Since the 1980s, short-term interest rates in the U.S. have fallen from more than 15% to the low single digits. Gross domestic product (GDP) growth in the U.S. remains weak, at about 2% per year, and prices on many consumer goods are currently stable—conditions that could signal a long period of modest investment-grade bond returns.
Although Treasury yields could fall more, higher rates are more likely over time. In a typical economic recovery, Treasury yields rise as investors begin to anticipate the impact of inflation. So far that hasn't happened. The recovery in the U.S. has been so slow that the Federal Reserve has kept interest rates low, in part by buying large quantities of Treasuries—more than $2 trillion so far—raising prices and suppressing yields. "The challenge for our fixed income team is finding value," says Kelson. "We're seeking opportunities in emerging markets and higher-yielding debt in regions with strong growth prospects."
High Yield. Credit risk is the central concern for an investment team analyzing corporate securities. Investors get paid higher interest rates as they take on more risk. Because high yield bonds—also known as "junk" or noninvestment-grade bonds—are considered to have greater credit risks, they offer very high rates. Companies in high-risk industries or debt-burdened countries, such as Greece or Spain, may fall into the junk category. At the top of the credit rating scale are AAA rated bonds. The rating tells investors they can have a high degree of confidence that the companies will make their semiannual interest payments—also called coupon payments—on time and that, when the bond matures, they will receive the par, or face value, of the bond. But the return is much smaller—between 2% and 3% for corporate issues.
A Flight to QualityThe Fed isn't the only buyer keeping rates low. Major U.S. trading partners China and Japan have used their trade reserves to purchase Treasuries for years. "Flight to quality" investors concerned with the situation in the eurozone have been putting money into Treasuries as well.
Emerging Markets. Countries such as Brazil, China, and India have become world economic leaders and dominant sources of global growth. The political climate and economic foundations in many of these markets—rapidly growing middle classes spurring consumer spending, for example—offer the potential for greater returns. Here are some features of these markets:
- Corporate bonds are largely investment-grade
- Economies generally have fewer headwinds than in
developed markets, which are facing austerity measures
- Nondollar-denominated bonds provide positive real yields and could benefit from foreign currency appreciation if the dollar declines over time.
Macroeconomic conditions in countries or regions also can have wide-ranging and lasting impacts on securities. Rapid growth in China, for example, has led to higher inflation—particularly for food and energy. Rising prices have increased manufacturing costs, which have tightened profit margins of some firms, both in the country and in those around the world with production facilities in China. Some observers have warned of a significant downturn for the Chinese economy, but Kelson disagrees. "The economy has grown at around 9% over the past five years," he says. "If it tapers off to 7% or 7.5%, it would still be compelling against growth rates in the U.S., Europe, and Japan. Indeed, much of the emerging markets sector is trending toward higher growth rates—and that's where we're looking for long-term, above-average returns."
NEW FUNDS FOR A CHANGING INVESTMENT WORLD
T. Rowe Price has launched a number of new funds designed to take advantage of the changing global financial landscape and provide exposure to countries that are growing more rapidly than those in the developed world. The new products offer an important source of diversification that helps reduce the risk associated with being overly exposed to one sector or region. Observes Kelson, "Diversification can help protect you during the difficult cycles that we've seen already in developed markets—and that I'm sure we'll continue to see."
The T. Rowe Price Emerging Markets Local Currency Bond Fund (PRELX), launched in May 2011, offers a way to broaden exposure beyond dollar-based assets and protection against a decline in the dollar's value. The fund seeks to invest in securities where the combination of fixed income returns and currency exchange rates appears attractive.
The T. Rowe Price Floating Rate Fund (PRFRX) aims to offer attractive income and a hedge against inflation by investing in noninvestment-grade bank loans. The loans are short term, and the interest rates they pay adjust every month or quarter based on the London Interbank Offered Rate (LIBOR), a value set by major banks in Europe. The interest rates on fund holdings may rise or fall in response to general economic conditions.
The T. Rowe Price Emerging Markets Corporate Bond Fund (TRECX) seeks high income and capital appreciation by selectively investing in bonds issued by companies located—or conducting the predominant part of their business—in Latin America, Asia, Europe, Africa, and the Middle East. The fund offers more direct exposure to the economic growth of emerging markets than the sovereign bonds issued by these countries, with less volatility than local stocks.
Photo: Getty Images
YOUR ROLE AS A FIXED INCOME INVESTOR
Knowing how interest rates or credit ratings may change—among myriad other factors—is challenging. Spreading your investments among a variety of asset classes and diversifying within those classes is a wise approach. Your first step should be to establish an asset allocation—the mix of stocks, bonds, and short-term investments—that is in line with your time horizon. Your mix of stocks and bonds should change as you near your goal. To help protect your savings against stock market volatility, bonds should become a greater portion of your investments over time. In constructing your fixed income portfolio, however, please remember that not all bond funds are alike and that the environment for bonds is always changing. That makes it all the more challenging to find investments to match your goals.
To reach your objective with an effective balance of growth potential and risk, you should hold a wide range of stock and bond sub-asset classes—including exposure to domestic and international assets. If you opt to hold individual securities, spread your bond holdings among securities that vary by maturity, credit quality, and interest rate sensitivity. In creating a mix of bond funds, try to minimize overlap within your portfolio—when two or more funds hold the same security or provide exposure to the same industry or region.
Given today's complex markets, investing in bonds requires expertise and research. The feature story, "How Investment Professionals Make Decisions," offers an in-depth look at the rigorous process employed by the T. Rowe Price global network of investment professionals and the collaboration that informs their decisions. The results of this teamwork are mutual funds that leverage the firm's expertise and offer the diversification that you need among your fixed income holdings.
Investing in the securities of non-U.S. companies involves special risks not typically associated with investing in U.S. companies. Foreign securities tend to be more volatile and less liquid than investments in U.S. securities, and may lose value because of adverse political, social, or economic developments overseas or due to changes in the exchange rates between foreign currencies and the U.S. dollar. Investments in emerging markets are subject to abrupt and severe price declines, and should be regarded as speculative. The economic and political structures of developing nations, in most cases, do not compare favorably with the U.S. or other developed countries in terms of wealth and stability, and their financial markets often lack liquidity. Diversification cannot assure a profit or protect against loss in a declining market.