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Global Fixed Income Investment Themes in 2014

Higher Interest Rates

FRAN RODILOSSO: Looking forward in 2014, the Treasury market may see higher rates still.  In fact, it might not be a bad thing if we see 10-year bond yields finish the year at 3.5%.  It would be an indication that the U.S. economy is continuing to grow at an acceptable rate, but is not out of control.  You have to remember that we are still in a period of extremely accommodative monetary policy.  The Fed funds rate is held near 0% and will be, according to the Fed, through the end of 2014 and possibly through the end of 2015.

Impact of Fed Tapering

RODILOSSO: The market expects that the Fed will continue tapering its asset purchases throughout 2014, and perhaps be done with QE3 by the third quarter of this year and this will impact fixed-income markets.  There may be less demand for a variety of fixed-income instruments, and investors may move back down the risk curve.  It may have negative implications from a technical point of view for high-yield and emerging market bonds.

EM Bond Markets Outlook

RODILOSSO: Prospects for emerging markets debt in 2014 are probably better than they began last year.  Emerging markets debt was an area that did revalue in 2013.  Technicals were fairly weak heading into May, when taper talk began.  Hedge funds and retail investors, in particular, were sellers of local currency and hard currency debt.  What we're seeing as we head into 2014 are many countries whose yield curves in their home currencies are a lot higher in terms of yield, whose currencies are a lot weaker, and who are making adjustments – some are even hiking short-term interest rates, such as Brazil, to correct what's going on in their economies.  The point for emerging markets in 2014 is that valuations have adjusted.  They may or may not fully reflect the risk we're going to see play out this year, particularly with elections in many countries, and with several countries still experiencing fairly meaningful current-account deficits.

Investment Themes for 2014

RODILOSSO: As a fixed-income investor, some key themes we’re thinking about in 2014 really are not that different from 2013.  Shortening duration appears to make sense.  Taking on credit risk to help make up for the loss of yield by moving shorter duration also still makes sense.  We're still in a low default rate environment.  We're still in a situation where companies are able to refinance at even lower rates.  Many borrowers in the U.S. and abroad have pushed out their maturity schedules, therefore at least lowering the risk of default in the near- to medium-term.  Some companies, for sure, have increased their leverage.  From that point of view, credit may not be cheap.  However, it does not look like a bubble or incredibly expensive.  Including emerging markets in fixed-income portfolios for 2014 still makes sense.  That did not work out so well in 2013, for sure.  But emerging markets, as mentioned earlier, have adjusted.  Valuations have changed.  Yields have gone up, even on corporate debt denominated in dollars.  Whereas in the U.S., credit spreads on high-yield narrowed significantly in 2013, in emerging markets, they widened marginally.  The relative valuation of emerging markets debt versus developed markets debt looks more attractive now. We believe you're getting compensated for a lot of the risks in emerging markets.

There are various tools for investors to use in their fixed-income portfolios in order to achieve some of these themes.  Shortening duration can be done by selling fixed-income.  It can be done by buying short-duration corporate funds.  It can be done by buying floating-rate note funds, bank loans, treasury-hedged funds.  There are a variety of ways to lower duration.  I should also mention that in the high-yield universe, both Europe and emerging markets have shorter durations than the U.S. high-yield universe.  As I mentioned earlier, emerging markets have a significant yield pickup over U.S. high-yield corporates.

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