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I V

A More Challenging Year for Fixed Income Investing

Corporate bond investors enjoyed back-to-back stellar returns during the past two years, but with interest rates like y to rise furthe , expectations are more subdued. Steve Hube , manager of the Stra- tegic Income Fund, which invests in multiple global bond sectors, discusses the outlook for xed income investing.

Q.How do you view the general financial health of corporate borrow- ers and the state of the fixed income markets now—almost two years after the recession officially ended?

A. Corporations are in much better fundamental shape. The new issue markets allowed them to renance their debt and extend their maturity prole, and they have relatively high levels of cash on their balance sheets, which should allow them to better navigate through a protracted economic recovery. We expect a slow-growing economy, and we’re focused on how topline revenue growth and prots hold up under these conditions.

Q.Interest rates have risen modestly this year, but the average yield for investment-grade corporates was recently about 4.1% and junk bond yields fell to about 7%—near the all-time low in 2004. Do corporate yields adequately compensate investors for the credit risk?

A. While absolute yields are at historically low levels, yields relative to alternative sectors still look somewhat compelling. High yield bonds offer a 500-basis-point [ve-percentage-point] spread over comparable Treasuries—still meaningful, though well below levels of the past two years. Credit sectors continue to benet from the liquidity in the market, and corporate credit quality has improved signicantly. Defaults in the high yield market have fallen dramatically, though we have seen some decline in the quality of new issues and early signs of specula- tive behavior in that market recently.

Q.What’s your perspective on the Treasury market?

A. Treasury yields also have risen this year, to about 3.50% recently on the 10-year bond. Yields are up largely because of increased ination expectations, partly driven by the

Fed’s QE2 [its second quantitative easing] program of buying Treasur- ies, which is supportive for yields as an additional source of demand but also adds to longer-term ination concerns given the magnitude of liquidity injection.

We expect rates to trend higher longer term, as the Fed ends QE2 Treasury purchases in June, decit levels remain high, and the economy continues to recover. Ination could also trend modestly higher but is not a concern for the time being. The yield on the 10-year bond could reach 4.25% to 4.50% a year from now, but the path will likely be interrupted by periodic bouts of risk aversion such as we’ve recently experienced with events in the Middle East, Japan, and Europe. Shorter-term yields should also rise once the Fed signals its intention to remove policy accom- modation, which could begin in the second half of 2011.

Q.So has the 30-year secular decline in interest rates finally come to an end?

A. I would say we reached the low in rates toward the end of 2008.

As for the general state of the mar- kets, corporate credit has surprised us with the speed and magnitude in the tightening of yield spreads over Trea- suries. As long as the Fed is providing liquidity, these spreads should stay relatively contained at these lower levels and corporate credits should do well, at least for the rst half of the year. But as we get closer to Fed tightening, perhaps in the second half, we would suggest that a more cautious approach to credit sectors could be warranted.

2 Years

0.75%

-0.99%

-1.49%

-1.98%

5 Years

2.25

-2.40

-3.59

-4.79

10 Years

3.62

-4.28

-6.42

-8.56

30 Years

4.75

-8.31

-12.46

-16.61

How Rising Interest Rates Affect Treasury Bond Prices

Bond Maturity

Change in Principal Value of Bonds With $1,000 Face Value

Coupon

50 Basis Points

Rates Increase By:

75 Basis Points

100 Basis Points

Average coupons on Treasury securities provided as of 3/31/11. Price changes are apart from fluctuations caused by other market conditions or factors. 100 basis points equal one percentage point. The table may not be representative of price changes for mortgage-backed securities because of prepayments. This chart is shown or illustrative purposes only and does not represent the per ormance of any specific security.

Source: T. Rowe Price.

12 www.troweprice.com

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