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By Jeremy Glaser | 11-06-2012 09:00 AM

Understand Why You Invest in Bonds

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.

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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