Home>Video>Understand Why You Invest in Bonds

Understand Why You Invest in Bonds

Tue, 6 Nov 2012

With very low interest rates, as well as uncertainties about inflation and the muni market, it's time for investors to really rethink the purpose of their fixed-income allocations, says Fidelity's Christine Thompson.

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Video Transcript

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm very pleased to be joined today by Christine Thompson. She is the chief investment officer of the Fidelity bond division.

Christine, thanks so much for talking with me.

Christine Thompson: Thanks for having us in.

Glaser: So, certainly there are a lot of headwinds potentially facing bond investors, particularly this very low-interest rate policy that the Federal Reserve has been implementing for years now. Some people have been calling it financial repression. I just want to talk a little bit about some of those difficulties and how investors could really grapple with them.

The first is, where are the places that people could really find yield right now? Are there any areas in the fixed-income market where investors can get some extra income without taking on a tremendous amount of extra risk?

Thompson: Right. I will start by reminding everyone that you have to approach your investing by recognizing where you are in any kind of a business or economic cycle, and right now where we are is at a pretty extreme point in a pretty unusual cycle, which means at low interest-rate levels, you are not going to be able to get the kind of income that you would on average over time looking historically.

So, starting with that realistic view and recognizing the uncertainties that exist in the U.S. economy and really economies globally, it's time to understand why you are investing in different products for what purposes and to think about good core principles that apply throughout times, such as diversification.

At current yield levels as you approach the bond market, it's really important to understand what's you are investing in and how it fits into your diversified portfolio. If you're driven into bonds because you are really concerned about capital preservation, probably what you don't want to do is to be chasing incremental yield. Yes, you want yield, but generally it's also part of an investment goal where you want capital preservation. And to do that you have to understand what risks you are taking. It doesn't mean that you can't incrementally add to the yield of a portfolio, it's certainly not necessary to own the absolute risk-free assets of Treasury bonds or T-bills. But if you go too far, if you reach too far, you are putting yourself in a position where the expected returns of those portfolios as the economy evolves, as interest rates sort of continue sort of their path in response to what economic activity is doing, are going to lead you into a place that you could be disappointed.

Our focus at Fidelity is to make sure that we manage all of our products, all of our funds, in ways that investors can use them appropriately as they consider them as building blocks and part of a diversified portfolio. If you want capital preservation, you should be thinking about how much volatility you can weather, over what time horizon in order to achieve your investment goals. That may mean moving out on the yield curve in order to pick up incremental yield in that direction. It may mean moving down in credit quality. It may mean accepting a wider variety of types of securities that might involve structural risk and uncertainty with regard to the time of prepayment, which means where interest rates are when you have to reinvest prepaid securities might be the most important factor driving your absolute return.

So, in summary, it's a time to understand why you are investing in bonds, how they fit into your portfolio, whether you are seeking high total returns, whether you are seeking steady income, and how much volatility you can weather if you are concerned about capital preservation.

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Glaser: Inflation is a concern that many investors have. It's not something that we've seen a ton of so far, but with this new round of quantitative easing, certainly those fears have been somewhat reignited. Are you worried about inflation, and should investors be trying to protect themselves from it?

Thompson: We always worry about inflation, but it's interesting because a lot of the governmental policies are actually working very hard to avoid deflation in the economy. So there's really a tremendous amount of uncertainty with regard to where the economy is going to go, what governmental policies will do, and what investors should be worried about.

To worry about inflation is really kind of an optimistic outlook. It means that we think that the government policymakers will be successful in avoiding deflationary-spiral-types of scenarios, which is what they are working really hard to do with QE and with interest rates being as low as they are.

The core goal of those policies is to encourage investors to allocate their capital in areas that will help the economy grow and expand. That incurs taking more risk, but it also has the potential down the road if they're successful to reintroduce inflation into the U.S. economy.

So, it's something to consider. My guess is that in the near term, meaning in the next year, year-and-a-half it's not going to be a factor that's going to be driving investment returns.

Glaser: How about rising rates? Will that be a problem anytime in the near future, even the medium future?

Thompson: Well, again, before you get to what's going to drive interest rates, what's going to drive inflation, you have to think about what are sort of the dynamics that are driving growth in the U.S. economy. Some of the concerns, some of the uncertainties, some of the pressures are leading us into the environment where interest rates are so low.

So, again, as the economy begins to grow, yes, we think interest rates will sort of follow that growth trajectory. But right now, we are in an economy where slow-moderate growth is what we expect, is what many governmental policies are pushing to ensure continues, and we'll have to see how the results of the election and the policies that follow that as it relates to the factors that will determine whether or not the U.S. economy is going to continue to expand.

Glaser: Let's shift our focus a little bit to the municipal-bond market. Certainly, there are some high-profile municipal bankruptcies, but there hasn't been just a huge wave of defaults in this space. Do you expect that credit quality will improve in the muni market? How should investors think about those bonds right now?

Thompson: Right. I think in approaching the municipal market it's important to recognize the diversity of issuers that issue debt in that marketplace. Some of the market analysts who are predicting skyrocketing bankruptcies were drawing on real fundamental pressures, but extrapolating those to a degree that just never made sense to our analysts.

Municipal credit is such that it follows the health of the economy. The revenues that back most municipal bonds are either taxes or fees so that when economic activity falls, when unemployment falls, when consumer spending declines, the amount of revenues flowing into the municipalities and their agencies that issue debt is declining. So it's sort of a lagging indicator to the rest of the economy.

When you go into the down part of a cycle, most municipal issuers have rainy-day funds, different ways that they can bring supplemental revenues in so that they continue to provide their services. As you move along into sort of a tough fiscal cycle, you run out of those easy fixes, and that's where municipalities are now. They are at the point where they need to make real changes in the balance of their revenues and their spending in order to put forth balanced budgets, which at a state level 49 out of the 50 states are required to do. And so you are beginning to see those who take really prudent fiscal decisions perform well, and you have those who don't have either the flexibility, have exhausted avenues that they can turn, or are facing political gridlock, hitting real serious fiscal challenges.

So the way to invest in that market is understand who you're investing in, do the work, and understand that not all municipal bonds can be treated in a homogeneous fashion. And this is an environment where investing through a fund company like Fidelity where we have a team of close to 30 people who are working on picking the issuers will probably serve investors well.

Glaser: It sounds like it's a bond-pickers' market there. Earlier you mentioned that you either have to decide to move out further on the yield curve to take that duration risk or you have to take more credit risk. In your opinion, the bond market in general, which of those looks more attractive right now?

Thompson: I think it's all about sort of balance relative to the specific product. The way we approach investing is, first and foremost, you have to know what your goal is; you have to know what the expectations are of the clients that invest in the portfolios that you are managing. So, whether it's duration risk, whether it's credit quality, or whether it's structural risk, it's going to be a function of the specific portfolio.

There are accounts where you have wider latitudes, where they have the ability to move back and forth and to collect sort of their value, added in different ways. And in those markets there is probably a preference to include a mixture of both. Look at values across the yield curve. The yield curve is very steep right now. So, there are ways to add return looking at how to position across the curves so that if you hit a rising-rate environment where short-term rates generally rise more than long-term rates, you can combine those in a fashion that will give you above-market returns.

Similarly, as you consider credit quality and opportunities by moving down the credit spectrum, there are many lower-quality issuers who really have pretty solid fundamentals. So, if you invest in those, it's a pretty good risk/reward proposition, but that doesn't mean that you can invest blindly sort of across those universes. Again, research matters, and understanding the dynamics and the fundamentals is probably going to be the best risk-mitigation strategy that you can build into portfolios.

Glaser: Christine, thank you for your insight today.

Thompson: Thank you very much for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.

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