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By Jeremy Glaser | 04-11-2013 12:00 PM

O'Neil: Bonds Poised for More Modest Returns

The mid-single-digit returns that fixed-income investors have become accustomed to are unlikely to be repeated, says Fidelity Total Bond manager Ford O'Neil.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

I'm joined today by Ford O'Neil; he is the portfolio manager of Gold-rated Fidelity Total Bond. We're going to talk a bit about his expectations for fixed-income returns over the next couple of years, and also his thoughts on Treasuries, high-yield investments, and also emerging markets.

Ford, thanks for joining me today.

Ford O'Neil: Jeremy, happy to be here.

Glaser: So let's start with a broad question. We've seen a lot of investor money flow into bond funds over the last couple of years, and even though performance has started to trail off a little bit, we've still seen those heavy flows. Do you think investor expectations in the fixed-income market are reasonable, or are people kind of expecting to see the returns in the last 10 years repeated over the next decade?

O'Neil: So, you've hit on a number of different topics and let me take them one at a time. It's been interesting there has been a lot of press about the great rotation that's starting. Really as you highlighted, bond flows have been very strong, and I would argue the great rotation started four years ago when people were leaving cash and money market and bank accounts and going into bonds. We've seen very, very strong flows for four-plus straight years … and really they're not abating this year as well.

And why is that? Well, we have a financial depression in the U.S. and also in a number of other countries, and with inflation running at 2%, it's just awfully challenging to earn 0% on your bank account. So, people are moving out the risk curve, and why are they doing that? Well, they need income, and bond funds are supplying the income that they used to receive in more conservative investments, and also you get diversification and capital preservation as well, relative to moving even further out the risk curve.

So I think that, to me, all seems logical. But your last point, which was an interesting one, was really about return expectations, and this is one thing we're trying to speak to our clients about. If you look at historical fund returns, people have gotten very comfortable with mid-single-digit returns on their bond funds, anywhere from 5% to 8% or 9%, depending upon how aggressively they were positioned. With bond math, it's pretty simple. You can't talk about P/E expansion getting you another 10% return in the fixed-income markets. And so with the starting yield on the Barclays Agg a little under 2% and spreads, in our opinion, having tightened quite a bit in 2012, looking fair, if not rich, our return expectations we're telling clients are a more modest zero to 4% range. Forget about those mid- to high-single-digit numbers that you have returned for five, 10, 30 years. I think the key is, the more modest return expectations going forward.

Glaser: You mentioned investors are going to have to get used to lower returns from their fixed-income portfolio, but recently taking on extra credit risk has been rewarded. What are your expectations for taking on more credit risk going forward in products like floating-rate funds or high yield?

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