Long-term U.S. Treasury bonds, mortgage-backed securities and corporate high-yield bonds could perform well this year even if the federal funds rate increases again, fixed-income money managers say.
Some say that even if rates do rise, they might not rise a lot, or won't rise for all bond maturities along the yield curve. As is often the case, expectations of the rate of inflation play a major factor in how fixed-income managers are positioning their portfolios.
William Gross, chief investment officer for Pacific Investment Management Co., Newport Beach, Calif., said PIMCO has reduced durations relative to their benchmarks by three to six months.
PIMCO portfolio managers also have put in place a barbell strategy, in which an investor chooses securities with maturities that are short and long, but not intermediate.
The barbell is one of three standard strategies fixed-income managers use when interest rates are expected to rise, Mr. Gross said. The others are to reduce a portfolio's duration, a measure of the length of a security's cash flows, and increase the credit quality of fixed-income investments, ahead of a presumable downturn in the economy that would follow higher interest rates.
But because the current economic recovery might be different than it has been in past business cycles, those strategies should be adapted to those differences, Mr. Gross said. Because inflation is perceived as less of a threat than in past business cycles, he explained, PIMCO's managers are looking for "less of a flattening" of the yield curve and less potential damage in long-term securities.
He said it "wouldn't be unreasonable" to expect this cycle to be muted, meaning "rates probably won't rise as much as in previous cycles."
James Goldberg, managing director for Trust Co. of the West, Los Angeles, agreed intermediate securities might get hit the worst if interest rates do rise, particularly in the three- to 10-year maturity range. Beyond a 10-year maturity, though, prices might have fallen "too hard relative to the inflation risk," he said.
"It's conceivable that 30-year bonds could rally" after another hike in the fed funds rate, Mr. Goldberg said.
Laura D. Alter, vice president and portfolio manager for Van Kampen Merritt Management Inc., Oakbrook Terrace, Ill., said a rise in interest rates could lead to "some stability in pre-payments" of principal on mortgage-backed securities, which in turn would make yields more predictable. Although Ms. Alter said mortgage-backed securities are likely to perform well on a relative basis, one concern would be extension risk - the risk that pre-payment rates will slow more than expected, again changing the yield of the investment.
Jon Knight, chief investment officer for Atlantic Portfolio Analytics & Management, Orlando, Fla., said that for APAM's more conservative clients concerned about higher interest rates and a possible increase in extension risk, its portfolio managers have swapped out of mortgage-backed securities trading at par value and lower, into U.S. Treasury securities.
For its more aggressive clients concerned about higher rates, APAM has invested in the interest-only stripped mortgage-backed securities market, which has rebounded and should continue to perform well, Mr. Knight said. Over the past four months, IOs with an 8% coupon have risen from a price of 14 to 23, he said. If rates move 50 basis points to 75 basis points higher, those 8% IOs could climb into the 30s, he added. Interest-only securities perform well when rates are rising because the number of cash flow payments increases as pre-payments slow.
And managers of corporate high-yield, or junk bonds, also see some good coming out of rising interest rates, because rising interest rates often mean the economy is growing.
For companies borrowing money through the junk bond market, an improving economy could lead to an improvement in business operations and possible upgrades from ratings agencies, said Matt Avery, senior portfolio manager for Franklin Management Inc. San Mateo, Calif.
Although PIMCO's Mr. Gross did not give junk bonds an endorsement, he said PIMCO's managers are "not as leery" of holdings in lower quality bonds as they might otherwise be in a rising interest environment. That is because any downturn in the economy is likely to be less severe than those in typical business cycles, he said.
Other managers, including John Paul Isaacson, executive vice president at Payden & Rygel, Los Angeles, agree the danger of rising interest rates from inflation may not be that great. Mr. Isaacson said current fixed-income yields are at levels that "pay you for taking on some yield curve risk."
Thomas Poor, managing director in the Boston office of Scudder, Stevens & Clark Inc., New York, said with current levels of inflation, a small rise in interest rates wouldn't necessarily be enough to offset the yield income of fixed-income investments. For example, a rise in rates of 100 basis points likely will still result in positive returns for short- and intermediate-term securities, he said.
In the near term, managers said volatility could continue in the bond markets. Payden & Rygel's Mr. Isaacson said he expects an increase in volatility to result from economic numbers that may jump around in coming months, giving fixed-income investors unclear signals about the directions of the economy.
The recent spate of bad weather in the East and Midwest and Southern California's earthquake are likely to distort the economic numbers that fixed-income investors rely on for information on the direction of the economy and inflation, he said.
