Bonds have been taking a beating in recent months as the Federal Reserve continues on its path to tighten monetary policy and will likely raise short-term interest rates two more times this year. But that doesn’t mean bond investors have to throw in the towel on all their fixed-income investments. Instead, Fidelity Investments‘ Julian Potenza, co-manager of the Fidelity Short-Term Bond Fund, said that investors should look for investment-grade bonds that have short durations.
“As the yield curve flattens, investors get less compensation for moving further out on the curve and taking on more duration risk. For long-term investors, long-term bonds still have a role to play in a diversified portfolio,” Potenza said in a recent Fidelity Investment Viewpoints report. “But for the more liquidity-focused part of an asset allocation strategy, now may be a good time for short-duration products.”
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According to the fund manager, a number of factors have been driving performance in the short-term bond market in recent weeks, including an increase in the supply of Treasury bills. The repatriation portion of the tax reform law has resulted in credit markets investing in short-term securities that have maturities under one year, which is also driving the performance. Potenza doesn’t view these as risks and thus has been looking for corporate bonds with attractive valuations. He also said that he is being selective as to which investments he chooses to include in the bond fund.
“Despite the cyclical strength of the economy, I’m cognizant of some of the longer-term challenges. One is that the current business cycle has been very long, and it’s going to have to end at some point. Another is that while credit spreads have widened recently, they’re still fairly tight by historical standards after corporate bonds posted several years of strong performance. What’s more, leverage has increased in some pockets of the corporate market. The result is an increase in fundamental risk,” said Potenza. The fund manager pointed to bonds issued by companies that are resilient and well run with strong balances sheets and credit profiles that are improving. On top of all that, the company has to have a fair value.
One area that has interested Potenza is bonds issued by banks. Since the Great Recession of 2008 and 2009, the regulatory environment has changed drastically for the banks in the U.S. and has resulted in strong balance sheets, much higher capital and more liquidity than in years past, said the fund manager. For companies that are farther along in their business cycle, Potenza said he keeps his durations shorter than for those that are earlier in the cycle. “It’s one way to earn attractive yields while helping to minimize exposure to a turn in the credit cycle and a period of spread widening,” he said.