Outlook '08: Fixed Income May Make Investors Defensive

Investors in US fixed income markets face a laundry list of uncertainties in 2008, which are likely to keep them on the defensive, analysts say.

Not least among the complications for investors is a market that has not exhibited textbook behavior. While the Federal Reserve is expected to ease monetary policy further to stave off recession -- typically helpful for bonds – there may be little if any payoff.

"The irony is that the economic environment will be favorable for bonds -- sluggish growth and low core inflation," said Cary Leahy, senior economist  at Decision Economics. "But the market has priced in so much bad news that weak growth may not be enough for it."

Some economists expect the US to skirt a recession in 2008. UBS Securities, for example, is forecasting 1.8 percent real GDP growth (year over year based on the fourth quarter of 2007), with weakness in homebuilding and continued tight credit conditions through mid-2008. The firm expects a low in the federal funds rate of 3.5 percent sometime in the first half of the year.

Others are unsure whether the economy will in fact be able to avoid recession. Indeed, questions remain about the impact of the credit crunch and real estate slump on consumers.

And strains from the sub-prime loans crisis persist in the money markets, negatively affecting how banks and investment firms fund themselves.

Treasury Market Signals

That's another oddity, given the historically low cost of borrowing. The Treasury market rally of 2007 took 10-year yields to a low of 3.79 percent on November 26 from 4.70 percent at the end of 2006.

Meanwhile, short-term Treasury yields slid in the fourth quarter of 2007 on flight-to-safety buying and expectations that the Fed would cut rates.

The two-year note traded below 3.0 percent, its lowest level since 2004.  The market got so far ahead of the Fed's 4.5 percent policy target set at the October meeting that market yields were discounting several Fed rate cuts to an almost unprecedented degree. On December 3, the gap between the two-year note yield and the federal funds rate was as large as 1.65 percentage points, about the same spread as before the Fed's first rate cut in the 2001 recession.

Now, analysts say that the upside potential for Treasuries is probably limited as the market has already factored in the worst-case scenario for the economy.

Looking into 2008, analysts hope to see a return to a proper balance.

"The name of the game is that the Fed and the two-year will meet in the middle," says Robert Barbera, chief economist at ITG. "Both will be closer to 3-1/2 percent by the middle of the year."

Time To Diversify

Given all that, the best defense for investors is to diversify. Yields on the 10-year Treasury are expected to stay in the low-to-mid 4-percent range.

"Given the heightened volatility and uncertainty going forward in the developed world and globally, we'd advise taking a diversified approach and having the ability to be somewhat nimble going into 2008," said Christopher Molumphy, chief investment officer at Franklin Templeton Fixed Income Group. 

Fran Kinniry, principal at Vanguard Investment Counseling & Research, agrees, adding, "Diversification and cost management are key."

After August 2007, when the financial markets crisis broke, fixed-income investors moved into the safety of government debt away from so-called spread products, such as corporate bonds and mortgage-backed bonds, instruments which trade at a higher yield, or spread, to Treasuries in order to compensate buyers for the greater risk.

Now some investors may be ready to re-evaluate that move in search of more opportunity.

"We see some sectors that have been impacted by the sub-prime mortgage fallout, but where fundamentals remain fairly healthy," said Molumphy of Franklin Templeton.

Comeback In The Cards

Sectors that investors may now take a second look at include commercial mortgage-backed securities, investment-grade corporate bonds, bank loans and even high-yield corporate bonds. Municipal bonds are another area of interest.

Wan-Chong Kung, fixed-income portfolio manager at First American Funds, likes  certain asset-backed debt and commercial mortgage-backed securities.

"Credit cards and auto receivables have had spreads dragged out wider by doubts about consumer credit." she says. "But these areas continue to show very low delinquencies."

Kung notes that the Treasury Inflation-Protected Securities, or TIPS, market could benefit if the Fed is perceived to be between a rock and a hard place concerning growth versus inflation.

The Fed's favorite inflation gauge, the Personal Consumer Expenditures (PCE) Index is seen contained at 1.7-1.9 percent on a core level in 2008, versus an expected 1.8-1.9 percent rate in 2007, according to central bank projections.

But, even though core inflation is expected to be stable in 2008, food and energy may add to headline inflation, potentially causing investor worries about stagflation.

"You can certainly paint a scenario where the Fed is talking tough on inflation , but may not have any choice but to take care of growth. If they do, it would bode well for inflation risk premiums," says Kung.