Navigating Today’s Challenging Bond Environment

This analyst blog is part of our coverage of the 2016 Morningstar Investment Conference.

A standing-room-only crowd greeted Morningstar's Sarah Bush and her panelists at the Morningstar Investment Conference on Tuesday. Bush and panelists Rick Rieder from BlackRock, Carl Eichstaedt from Western Asset Management, and Mihir Worah fromPIMCO discussed the risks and opportunities in the bond market.

Bush began by asking the panelists what they expected to hear from the Federal Reserve when it wraps up its meeting Wednesday. All expect rates to remain unchanged.

Eichstaedt noted that the U.S. economy is doing all right, it's hard to argue with the employment rate, and inflation remains in check. Rieder agreed, but notes that some labor numbers have started to trend downward; as a result, he expects the Fed to leave the door open for a July hike. Rieder thinks there's just a 25% chance that the Fed will raise rates in July, and expects maybe one increase this year. Worah remains in the one-or-two-rate-hikes-this-year camp. What he'll be listening for: whether the Fed refers to labor market behavior. If it does, a hike may be on the table in July.

The panelists addressed the risks inherent in the bond market today, and how their firms are managing those risks.

Worah describes PIMCO's global outlook is "stable but not secure." He expects the U.S. economy to grow at 2% this year, while the worldwide economy "muddles along." Valuations across asset classes are ahead of fundamentals, he says. While that perhaps can continue for another year or two, this pattern isn’t sustainable longer term. Worah expects an "unravelling" in the next two to five years. As a result, PIMCO will focus on more defensive and high-quality bonds over time. In particular, Worah sees value in U.S. Treasuries, particularly Treasury Inflation Protected Securities.

Rieder, meanwhile, notes that cash flow worldwide is declining; in his mind, this is a critical dynamic. For starters, we're now living in a world where more people will be drawing from income. In addition, people are underestimating technology's impact on cash flow: Technological advances bring efficiencies, which will translate to less cash flow. As a result, says Rieder, we'll be living in a lower growth world. From a portfolio perspective, BlackRock wants to hoard cash flow and capture carry. He recommends that investors focus on high-quality credits and stick with those that are higher in the capital structure. He also suggests diversifying in parts of the world where you get paid to take the risk, such as Brazil.

Eichstaedt says he's slightly more positive than the other panelists. He thinks the worst is behind Europe, and views 2% growth in U.S. as "pretty good." Moreover, he noted that China isn't going into a "black hole." From a portfolio perspective, Western Asset Management is finding opportunities in commercial mortgage-backed securities.

"They're lined up for a pretty good run," he says. Agency mortgages, in contrast, are expensive, he says. So too are some sectors within the corporate-bond market, such as healthcare, which Eichstaedt expects to be in the crosshairs of Washington D.C.

The panelists also addressed the oft-discussed issue of liquidity risk and what it really means for investors. Eichstaedt noted that small pieces of bad news have a much larger impact in the bond market than they did five or 10 years ago, given that Wall Street no longer provides a back-stop. Yet liquidity risk can pose opportunity for "patient investors," says Worah.

At the end of the session, each panelist offered his best advice to bond investors.

Rieder stressed the importance of taking the right risks and diversifying globally, focusing on more stable cash flows. Eichstaedt said bottom-up research will be even more important. Worah suggested diversification and improving credit quality.