(Corrects headline, first bullet point and reference in second paragraph to Treasury bonds instead of T-bills, adds in second bullet point dropped word "credit")
* Potential for further rally in U.S. Treasury bonds is slim
* Non-agency MBS,better spreads than investment grade credit
LONDON, Nov 5 (Reuters) - U.S.-based asset manager Russell Investments said it was taking a cautious stance on U.S. and Japanese government bonds as yields are very low, preferring higher yielding credit and emerging market debt.
Gerard Fitzpatrick, who manages some $5 billion in Russell's global bond portfolios, said that U.S. Treasury bonds had rallied significantly ahead of the Federal Reserve's announcement that it would do another $600 billion of quantitative easing, and the potential for any further rallying is slim.
"U.S. duration in the portfolio was higher around the middle of year but we have reduced that, and we are now underweight versus the benchmark," he said.
Generally, the higher the duration in a bond portfolio, the greater the risk, as the price will drop more as interest rates start to rise.
Fitzpatrick, who is based in London, also trimmed the duration in Japanese government bonds. These traded down to a yield of 83 basis points for the 10-year after the Bank of Japan announced its own asset purchase programme.
"You always have to be ready for a sudden increase in bond yields," said Fitzpatrick. "The sector is quite expensive compared to historical levels, and you have to be aware of the risk of a big bond sell-off at short notice."
He said that such a sell-off could be triggered by a strong, unexpected reduction in U.S. unemployment numbers, signaling to the Fed that their QE job is done, and ultimately removing the Fed bid from bonds.
Russell's Global Bond Fund was up 10.6 percent in the 12 months to end-September, whilst its benchmark, the Barclays [BARCBB.UL] Capital Global Aggregate Index, was up 6.1 percent.
Fitzpatrick was also underweighting the euro due to continuing sovereign debt concerns in Greece, Ireland, Spain and Portugal. "There is a huge amount of indebtedness here so it would be surprising if they all came through this unscathed."
European authorities have signaled that any further pain incurred by a sovereign debt crisis will have to be shared with bondholders rather than simply borne by taxpayers, raising the possibility of a default or a debt restructuring.
In credit Fitzpatrick was overweighting high yield bonds, emerging market debt, and U.S. non-agency mortgage-backed securities (MBS), which are those issued by banks.
"The default rate for high yield has fallen to low single digits as the improvement in company balance sheets and low interest rates have helped companies repay debt," he said.
He said emerging market debt offered good diversification benefits, particularly local currency debt, whilst non-agency MBS were attractive because they offered wider spreads than investment grade corporate debt.
"Even net of defaults the return is higher (for MBS)," he said.
Although U.S. house prices are expected to fall a further 10 percent and delinquencies have been relatively high compared with the historical average, Fitzpatrick said that in some tranches of MBS there was still enough cash coming through to pay the investor.
"You do need to go through them quite carefully to pick the winners from the losers, but it has performed well over the last 18 months," he said. (Editing by Chris Vellacott, Sharon Lindores)