2013: bonds will continue to find buyers

 CIO PERSPECTIVE: FIXED INCOME
This is for investment professionals only and should not be relied upon by private investors.
December 2012
2013: bonds will continue to find buyers
Andrew Wells is Global Chief
Investment Office, for Fixed Income,
Investment Solutions and Real Estate at
Fidelity.
AT A GLANCE
The breadth and diversity of the fixed income asset class will continue to attract investors
in 2013. Ongoing concerns about uncertainty and volatility in financial markets will see
many investors retain a preference for lower-volatility assets. For those willing to take on a
little more risk in search of higher real yields, emerging market bonds are attractive,
particularly as currency appreciation could enhance returns. While the idea of a bond
bubble has become a subject of debate due to the strength of the flows into fixed income, I
see little scope for a reversal in the fundamental attractions of the asset class given the
likelihood of a low-growth environment in which central banks are committed to easy
monetary policy. Nevertheless, on the basis of the medium-term interest rate outlook, we
believe a shorter duration stance is appropriate.
In terms of economic growth outlook, the imminent threat posed by the US fiscal cliff is a concern.
If you go back to the debt ceiling issue which last came to a head in August 2011, the uncertainty
which that created caused a visible slowdown in US economic activity. We are starting to see
some poorer US data and the danger is that these are due to the uncertainty created by delayed
investment and spending. I do believe that the US Congress will ultimately muddle through by
agreeing a temporary solution.

2013 will see low economic growth in the
developed world and further quantitative
easing. Sovereign debt levels remain a
problem and deleveraging will be a multi-year
phenomenon.

Looking past the fiscal cliff, the US economy is
showing good signs of recovery, particularly
now that the housing sector is picking up.

High quality, developed market government
bonds look overvalued but could remain that
way given central bank demand and ongoing
uncertainty.
In the Euro-zone, the outlook is less encouraging. Purchasing managers’ indices (PMI) are coming
down, signalling that economic performance is deteriorating and will likely translate into a broaderbased fall in GDP. This is bad for employment prospects and will cause a drag on economic
performance especially in the peripheral economies, such as Spain and Italy.

Investment grade and high yield bonds remain
underpinned by solid credit fundamentals but
return expectations have to be moderated for
2013.

Emerging debt markets are attractive, with
capital likely to flow to higher-yielding
currencies boosting locally denominated
returns.
Overall, the fundamental problems for economies remain, particularly the amount of debt within the
system. In developed markets, gross government debt as a percentage of GDP is still increasing,
as are government deficits as a percentage of GDP Over time, as debt is slowly reduced, we will
start to see an economic recovery get under way but a long period of deleveraging in the US and
particularly in the Euro-zone is in store. This means we can expect more of the same in 2013; a
low-growth environment that commits central banks to quantitative easing policies - similar to the
situation in the middle part of 2012.
Looking beyond this potential fiscal drag, we see US GDP growth in 2013 being somewhere
between 3 and 3.5%, which is some way above where we saw it only six months ago. A large part
of this is predicated on signs of a stronger recovery in the US housing market. House prices are
picking up, there is relatively low housing stock in some areas and turnover is also rising. At the
same time, employment is beginning to improve and the US consumer is starting to spend a bit
more. This is all positive for economic growth at a measured pace. In China, industrial production
growth is bottoming out and conditions for a recovery are gathering steam; this will have a positive
impact on Asian markets.
We are only part way through the QE journey. At this stage, there are some signs of the strategy
having the desired effects. In the US, unemployment is starting to come down, and there is a
school of thought that QE is the most viable, least damaging solution available. I would expect QE
to be pursued throughout 2013 on effectively a global basis, led by the US Fed, the ECB, the Bank
of England and the Bank of Japan. Indeed, monetary policy will remain stimulative for a sustained
period, and we are unlikely to see interest rate hikes in the US until 2015. Quantitative easing does
continues to pose a significant tail risk given the massive expansion we are seeing in central bank
balance sheets, and inflation could become more problematic as we head into 2014.
The idea of a bond bubble in fixed income markets is beginning to concern some investors, given
the inflows we have seen in fixed income markets. In my view, to fundamentally reverse the strong
trend in bond markets, you have to assume that we are entering a high-growth environment where
interest rates are going up, and in which the fundamentals of fixed income investing become
challenged. The probability of this is remote; I do not anticipate the kind of higher growth
environment in 2013 that would force interest rates higher globally.
CIO PERSPECTIVE: FIXED INCOME
Many investors remain concerned about volatility and uncertainty, which will continue to draw them
to towards fixed income as an asset class. And, within fixed income there is a great deal of
diversity.
In developed markets, high-quality government bonds do indeed appear overvalued versus our fair
value models. This could, in fact, remain the case for some time however, given heightened
uncertainty and a reduced supply of high quality assets - much of which is being bought up by QE
programmes. If and when economic recovery becomes more established, the gap between current
government bond yields and measures of fair value are likely to close. As such, investors need to
mindful of the duration of their assets; a preference for shorter-duration assets may help to guard
against this risk.
In investment grade credit, credit fundamentals remain positive overall and balance sheets are
largely robust. Spreads are still attractive but do offer more limited scope for compression
compared with the experience of the last three years. There is also a danger that some companies
will take advantage of cheap financing and start to re-leverage their balance sheets for M&A, share
buy-backs and dividend purposes. That could cause some credit ratings to drift downwards, so a
fundamental research-driven approach to credit selection is vital.
We continue to see some value in high-yield markets, but we think investors should focus on the
high quality end of the market. Investors should also be realistic about prospects for 2013; the
exceptional returns of recent years will not be repeated. We can expect high yield bonds to offer
attractive positive carry rather than strong capital appreciation prospects, and we’re likely to see
returns in the high single digits rather than the double digits.
Emerging market debt has been a positive asset class in the past year and one that remains
attractive given the prospect of capital flowing to higher-yielding currencies. There is a strong
correlation between emerging market PMIs and emerging market foreign exchange. If we see a
gradual global recovery taking shape, we should expect to see a pick-up in emerging market
foreign exchange returns. The next leg of this rally though will not necessarily be in hard currency
bonds; it is likely be in corporate bonds and local currency issues.
Lastly, investors should be wary of latent inflation risk as 2014 approaches. This makes inflation
protected strategies attractive but the caveat is these bonds typically perform better in a higher
growth environment and the longer duration structure of many developed market issues introduces
undesirable interest rate risk. A better inflation-hedging strategy may be to increase exposure to
emerging market inflation-linked bonds, which are supported by higher economic growth rates;
these bonds would be well placed to perform well if the global economy strengthens.
Given the diversity of opportunities within fixed income, a strategic approach to investing in the
asset class will remain popular with investors as we enter 2013. Those bond funds with the
flexibility to allocate across bond categories and tactically tilt their firepower to the most attractive
areas are well positioned to provide an attractive risk-adjusted return to investors in an
environment with so many economic uncertainties.
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CIO PERSPECTIVE: FIXED INCOME
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