O’Neil: TIPS Attractive as Inflation Worries Grow

Emory Zink: Hello, I'm Emory Zink for Morningstar. Today I'm joined by Ford O'Neil, portfolio manager with Fidelity Total Bond, our 2016 fixed-income manager of the year. We're going to discuss what went well in 2016 and how he's positioning the portfolio going forward.

Ford, thank you for joining us.

Ford O'Neil: It's great to be here.

Zink: Sort of kicking off, 2016 was a stellar year for Fidelity Total Bond. What were some of the high points of that positioning?

O'Neil: We did have a good year. It was driven by both security selection and also sector allocation decisions that we made. Corporate bonds were really the key to our performance in 2016. Investment-grade corporate bonds, especially those in the energy sector, added a lot of value. Energy pipelines especially were one of our favorite subsectors. In addition to investment-grade corporate bonds, high-yield bonds and leveraged loans were two other sectors that we owned in the portfolio that also generated double-digit returns. Overall, corporate bonds helped, and we also added a little bit of emerging markets. Latin American emerging markets, especially, were a positive driver to our overall portfolio.

Zink: That's really interesting. It's sort of transitioning out of the positioning for this past year and into the coming year. I know everybody's been watching the Federal Reserve. We're curious what's going to be going on with the U.S. economy. What are your thoughts on that?

O'Neil: First we'll start with the economy. The U.S. economy actually had a fairly strong fourth quarter of last year. There's a fair amount of momentum going into the year, so that's good news, especially for our corporate bond positions. Clearly there's some animal spirits alive as well that are also helping with the risk on positions in our portfolio.

I think we're feeling the economy will be a little bit stronger, but not materially in 2017. What we are nervous about is inflation. We're starting to see a material pickup in inflation. Clearly the commodity complex is rolling over and those energy prices are now putting some pressure on inflation. We're also nervous about core inflation and possibly wage pressures as well. That's an area where obviously if you're a bond investor you want to be careful and cautious about.

With regard to rates, we're hoping that interest rates normalize at some point. We've been, are eight years into the recovery, and they're still what we would argue a little on the low side relative to where we believe the fundamentals should be. Overall, we're optimistic about the economy.

I think one thing that we're really trying to focus on, obviously, is the current president. The key question we're asking ourselves, is he a pro-growth president or is he a protectionist president. I think that's going to, the answer to that question will determine where markets go this year.

Zink: Even though there were a lot of uncertainties, given what you've just discussed with us, how are you positioning the portfolio going forward as of right now?

O'Neil: A year ago we talked about the portfolio being fairly aggressively positioned because there were a lot of really cheap attractive sectors. What I would argue now is obviously with the rally we've had, those sectors are less attractive. We would argue, we would be underweight Treasuries and agency mortgages because we think those are even less attractive. I think that's our home base, is thinking about those government guaranteed sectors don't have a lot of value. That means that we still are overweight corporate bonds but less so than we were a year ago. We think there's value in TIPS as we talked about. Concerns about inflation, Treasury Inflation-Protected Securities I think are a great place.

With the Fed potentially on the move hiking a few times this year, according to Chairman Yellen, we think leveraged loans with their resets also could be a nice place to be. There are still pockets of opportunity in corporate bonds. The one that we really find attractive today is financials. Again, we felt that they were near fair value last year, but now if we do get less regulation, if we do get higher rates in the front end to take advantage of their short portfolios, and lastly if they get lower taxes--obviously they pay a lot in taxes--those are all wonderful tailwinds for financials. We do feel there's still pockets of opportunity in the market today.

Zink: Thank you for those insights, Ford.

O'Neil: Great, it was great to be here. Thanks, Emory.

Zink: This is Emory Zink for Morningstar. Thank you for watching.