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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 anumber 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?


O'Neil: So when we think about credit risk, it's really all about starting with our macro overview. So, we start with the Fed and the government. On the Fed side, we believe in low for long. So we think there's going to be low rates and QE, if needed, for quite a while. That's, obviously, a benign environment. We also feel that fiscal policy will be somewhat contractionary. So given that combination, we think GDP sort of bumps along at 2%-plus, and that's good for credit. Credit doesn't necessarily need robust growth to do well.

So, overall, if you break it down in terms of sectors, we think investment-grade credit had a very strong run in 2012. We still like financials over industrials. They had a very good year in 2012. Industrials we're more worried about, with event risk. You're seeing LBOs coming back for Dell and Heinz. To us, those CEOs are becoming more equity focused, less bond focused.

One small market in investment-grade, also, we like utilities a lot. A good example is we're buying a lot of the pipeline sector. We feel that no matter where natural gas prices are, that's a sector that's going to do extremely well.

But you also did mention high-yield and also leveraged loan--they're cousins. Our overall feeling with high yield is, when we think about whether to own it or not, we think default rates, the dollar price, yield-to-maturity, and also spreads. Default rates, we feel, will be fairly low in the next couple of years. That's good news for high-yield. Spreads are fair relative to history, that's good news. But dollar price and yield-to-maturity are at all-time highs and lows. So, we think that it's going to be much more of a security selector market going forward. But they also have the opposite of industrial and investment-grade bonds; they have positive event risk. Now, many of these companies are being bought, so that's good news.

The leveraged loan side, we're a little more cautious. As their prices approach par, it creates this bond geek term, "negative credit convexity." So we don't see a lot of upside in leveraged loans at this point.

Glaser: Let's talk a little bit more about the Fed. You mentioned that you thought rates are going to be low for a long time. How does that make you think about government securities and their attractiveness today? Do you think the Fed is going to be able to gracefully exit itself from this low interest rate policy, or is that going to be more of a bumpy ride?

O'Neil: Sure. Let's turn to Treasuries. One thing that I always find amusing is this concept of a bond bubble. Having lived through the Internet/tech period of 10 years ago, and then more recently the housing boom, when people lost more than half their money, to me that's bubble-like. In Treasuries, the government is actually going to give you all your money back. So I would argue that this whole concept of a bubble is a fallacy.

Interest rates are at historically low levels, and the Fed is buying them. So there's probably not a lot of upside from a capital appreciation perspective. But I also still think they serve a purpose, and let's talk about the yield curve. Right now, we were underweighting shorter-term Treasuries, because we really don't think that there's a lot of value relative to cash. But where we do like Treasuries is 10-year and 30-year Treasuries, and yes, the rates are very, very low. But if you do get another period where the markets get a little wobbly, equity markets go down, 10-year and 30-year Treasuries are the only thing that may be going up in your portfolio. So we still think that there is a place for longer-term Treasuries. But we would differentiate between nominals and TIPS. We don't think that TIPS offer a lot of value today.

Then, just in terms of QE, our feeling on QE is that they won't be tapering anytime soon. So that worry, in our opinion, is something that, again, will get a lot of press, but not something we're concerned about. I think, it's more an end-of-this-year, if not 2014, concern.

Then what's interesting is that, when they tapered QE and ended QE1 and QE2, it was actually the equity markets that suffered; it wasn't the fixed-income markets, if you remember back in 2010 and 2011. Obviously, there's no reason why they can't start it back up.

So if, for some reason, you were to get rising interest rates, which the Fed would feel would curtail the economic rebound, there's no reason why they couldn't start it right back up the way they have with Operation Twist in QE1 and QE2 and QE3. So, … our view on Treasuries is not a lot of capital upside from a return perspective, but they still have a place, especially the 10 years and 30 years, in your portfolios today.

Glaser: Shifting gears a bit, you have the ability to go out and buy emerging-market debt in your fund, but currently have a fairly small allocation to it. Is that a view that you think emerging market debt is not attractive right now?

O'Neil: No, that's not the case. We still find it attractive, just not as attractive as it has been historically. So, as we look outside the U.S., we're finding it very hard to find value in either the developed or developing markets, and really the only place that we're seeing opportunities is in emerging markets. Now if you go back to your 1990s playbook, it was all about finding countries that not only had the ability to pay, but also the willingness to pay. … That was the criteria for buying emerging market debt.

Jeremy, there's been a structural shift in this marketplace in the last 10 years. Many of these countries went from being net debtors to the world now to being some of the world's largest creditor nations. With that shift there's been a shift from a ratings perspective. Less than 10% of them were investment-grade 10 years ago; more than half are today. What's obviously even more telling is that, as they are increasing in terms of credit quality, as I mentioned, some of those developed and developing nations are heading in the opposite direction, heading to non-investment grade status.

So days in which you could buy emerging-market debt at 500 or 1,000 basis points over, for the most part, are gone. But we still find pockets of opportunity in the investment-grade area. We think Mexico was very attractive, as is Brazil, and on the non-investment grade side, our EM team really likes Venezuela and Russia.

Glaser: Ford, I really appreciate you sharing your thoughts with us today.

O'Neil: Jeremy, happy to do so.

Glaser: For Morningstar, I'm Jeremy Glaser.

Jeremy Glaser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.