Fixed Income Outlook
Sponsored Content – American Century InvestmentsBy G. David MacEwen,
American Century Investments,
Chief Investment Officer, Fixed Income
February 28, 2012
Recent market volatility may have you wondering what to suggest when discussing your clients’ fixed-income portfolios. G. David MacEwen, Fixed Income Chief Investment Officer, offers guidance for portfolio positioning, especially for retirement-focused clients.
Pressured by a global economic slowdown, European sovereign debt concerns and risk aversion, many high-quality bond yields and interest rates plummeted below their 2008 levels in September 2011, before going back up again in October.
This environment has raised fixed-income positioning questions for your clients as you plan for 2012 and beyond, including what sectors we recommend and how we might allocate to those sectors.
It’s difficult to address all possible situations and scenarios. For this article, we will focus on fixed-income positioning within employer-sponsored retirement plans, both qualified (eligible for tax-deferral benefits) and non-qualified (not eligible for tax-deferral benefits). Please see the chart below.
These hypothetical plan allocations can also apply to other similar client account categories, either deferred [like IRAs and 401(k)s] or non-deferred, as in the case of taxable accounts.
Rationale for Our Hypothetical Tax-Deferred Positions
Core, diversified, intermediate-term bonds or funds
Our research shows that intermediate-term bonds typically outperform other maturity sectors on a risk/reward basis over time. Also, with our U.S. economic outlook calling for approximately 1-3% growth with no change in the Federal Reserve’s interest rate target until 2013, we believe intermediate-term interest rates will be relatively range-bound into 2012.
We believe recession is the greatest risk to our outlook. That would likely cause intermediate-term securities to underperform their long-term counterparts. On the opposite side of the interest rate risk spectrum, if your clients are concerned about rising interest rates, you can suggest substituting a shorter-maturity core diversified portfolio.
TIPS or TIPS funds
TIPS have been one of the best-performing sectors of the U.S. bond market this year, benefiting from declining interest rates.
By at least one key indicator, TIPS don’t appear overpriced to us. Since the 10-year breakeven rate (the difference between the yields of 10-year traditional Treasury securities and 10-year TIPS) dropped below 2.10% in August, the breakeven rate has remained near or below the 2% level that has represented good value for TIPS historically.
So, for long-term investors, we believe TIPS still represent effective inflation insurance. The U.S. continues to face possible inflationary pressures from rising rents, higher commodity prices, and a declining dollar. If your clients are concerned about the potential impact of rising interest rates on TIPS you can suggest a short-maturity TIPS portfolio.
High-yield corporate securities or funds
We believe this sector offers the highest potential returns going forward compared with U.S. Treasuries. Following sharp selloffs in June, August and September, we believe high-yield is pricing in recessionary expectations that are not yet entirely warranted.
Meanwhile, in this low interest rate environment, we think some of your clients will desire the yields offered by high-yield bonds. For your clients with high income needs and a high risk tolerance, high-yield allocations could be as high as 15%.
The risk your clients face in this sector is if we double-dip back into recession. High-yield moves very closely with the stock market, a correlation that tends to increase when stocks sell off. That is why high-yield plays just a supporting role in our hypothetical allocations.
International bonds or funds
The potential benefit of this sector is that it can perform relatively well when the U.S. dollar declines. We think low U.S. short-term interest rates, combined with difficulties in reducing the federal budget deficit, could continue to put long-term pressure on the dollar in coming years.
Rationale for Our Hypothetical Non Tax-Deferred Positions
Diversified, intermediate-term, primarily investment-grade munis or funds
We find intermediate-maturity munis attractive relative to their shorter- or longer-maturity counterparts.
Looking at the shorter maturity end of the muni spectrum, a backdrop of 1-4% anticipated annual inflation and money market interest rates near 0% could mean that your clients in short-maturity and money market muni instruments would lock in negative real (after inflation) yields for about two years. Intermediate-term munis should provide more yield. And compared with longer-maturity munis, intermediate-maturity munis still offer attractive yields with much less interest rate volatility.
It’s also worth noting that investment-grade muni values have become attractive again relative to U.S. Treasuries. Ten-year maturity munis now yield 100% or more of their U.S. Treasury counterparts. This represents significant value in a market where munis have typically yielded between 80-90% of comparable-maturity Treasuries.
High-yield muni funds
This sector stood out as one of the few remaining cheap sectors of the bond market even before the recent sell off in all risk assets. Now the sector has cheapened further—it has more positive correlation with stocks than investment-grade munis do.
But we believe muni defaults will remain low. And high-yield munis are much less correlated to equities than high-yield corporate bonds. Therefore, we continue to suggest that your taxable clients with long-term bond positions maintain high-yield muni allocations.
Your yield-oriented clients with greater risk tolerance can maintain up to a 20% weighting in this sector, while your more conservative clients would be better off with a 10% allocation. A period of rising interest rates would hurt the performance of high-yield munis, given their typically relatively long durations.
Important note: Fixed income is just one facet of a diversified investment strategy. We are not suggesting that your clients invest 100% in fixed income. Instead, these positions represent how your clients could hypothetically allocate just the fixed income portions of hypothetical diversified investment portfolios. We believe these portfolios should include appropriate percentages of both equities and fixed income, depending on goals, age, risk tolerance, and other individual preferences and circumstances.
These hypothetical muni positions are not just for your high tax bracket clients. While munis have enhanced appeal because of their after-tax income benefits, we still like these securities, even for lower tax bracket investors.
The opinions expressed are those of G. David MacEwen and the Fixed Income team at American Century Investments, and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.
You should consider a fund’s investment objectives, risks, and charges and expenses carefully before you invest. The fund’s prospectus or summary prospectus, which can be obtained by visiting americancentury.com/ipro, contains this and other information about the fund, and should be read carefully before investing. Investments are subject to market risk.
Diversification does not assure a profit, nor does it protect against loss of principal.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline. Investment income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax (AMT). Capital gains are not exempt from state and federal income tax.
P.O. Box 419385 | Kansas City, MO 64141-6385 | 1-800-345-6488 | www.americancentury.com/ipro
©2012 American Century Proprietary Holdings, Inc. All rights reserved.
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