HOW TO PLAY IT-Fed's taper portends year of the bond picker

Fri Dec 20, 2013 4:16pm EST

* Bond bull market over, tough environment seen in 2014

* Asset managers favor emerging market debt, preferred shares, high-yield

* Stay in short-duration debt to limit risks

By Andrea Hopkins

TORONTO, Dec 20 (Reuters) - It's been years since fixed income offered investors the "safe and stable" side of a portfolio, but Canadian asset managers believe the waves created by the Federal Reserve's tapering may make investing in bonds an especially bumpy ride in 2014.

The year ahead has been billed as one in which interest rates start creeping back to historical norms and the 30-year bond bull market comes to an end. But with economic growth still sub-par, Canadian money managers say there is money to be made in fixed income if investors pick the right spots.

"Our forecast is not for a bear market for fixed income in 2014, but we are at the initial stages at a rate normalization process, so I think it will be quite a challenging year," said Ilias Lagopoulos, a fixed-income strategist at RBC Dominion Securities.

After years of record lows, the yields on U.S. and Canadian 10-year bonds are expected to climb to around 3.4 percent or 3.5 percent by the end of 2014, Lagopoulos said, high enough to hurt investors who own government of Canada or Treasury bonds.

The bulk of the motion in fixed income in 2014 will come from the Fed, as it tapers its asset purchase program and removes stimulus from the economy. The U.S. central bank announced the beginning of the process this week, and the tapering could extend into 2015 as the U.S. economy improves.

As the biggest buyer in the Treasury market pulls back, long-term rates are expected to rise and prices fall. Bond prices will also come under pressure if U.S. and global economic pick up speed, and the need for the safe haven of bonds will decline as the crisis recedes - all of which may make for a very rough year for bond investors.

Still, most observers believe rates will only rise gradually, despite panicky headlines, and the Fed's pledge to hold benchmark rates lower for longer was seen as an attempt to reassure investors that low rates could persist for years, not months, to keep the U.S. growth on track.

Sadiq Adatia, chief investment officer at Sun Life Global Investments, said that while the end of the bonds bull market means it will be hard to make money in "plain vanilla" fixed income such as government bonds and high-grade corporate debt, opportunities exist further away from the Fed's influence.

"There are still a lot of opportunities if you go abroad. Emerging market debt offers great opportunities to get good yields, positive returns and benefit from growing emerging market nations," Adatia said.

"And people forget that bonds in these countries, about 60 percent are investment grade, so you're getting good returns and the risk is lower than people expect."

Alfred Lee, portfolio manager and investment strategist at BMO Global Asset Management, said some success in 2014 will be from shortening debt duration to between zero and five years to avoid being locked into low returns as rates rise. He also looks to some U.S. high-yield debt to offset the shorter durations.

Diversification is also important, and a rising rate environment is going to be one in which a good bond picker will do better than a passive manager, Lee said.

"One way to play a rising interest rate environment is going out and picking out bonds trading at a discount," he said, noting that more and more bonds are going to trade at a discount as rates rise.

"If you select those, and opportunistically pick off those bonds trading at discount and hold to maturity or near maturity, you're going to be able to mitigate your sensitivity to interest rates."

Lee said that while funds with a broad exposure to the bond market are unlikely to do well in 2014, an ETF like BMO's Ultra Short-Term bond ETF, which begins trading Jan. 1 and targets durations less than a year, should outperform.

NO CRYSTAL BALL

Darcy Briggs, co-lead manager for the Franklin Bissett Corporate Bond Fund, said he's only expecting low single-digit returns in fixed income as a whole in 2014. But he sees corporate bond funds as a better bet than government debt. He also likes some high-yield debt in industries such as oil and gas, but warns it comes with higher risk.

"2014 is going to be more bond picking - you're going to have to really do your homework in terms of what you expect company balance sheets to look like," said Briggs.

Another piece of the fixed income market that both Sun Life's Adatia and RBC's Lagopoulos like is preferred shares. They have suffered deeply as the year draws to a close and investors choose them for tax-loss selling, offloading them as large losers to offset capital gains.

"The selling pressure has caused the preferred share selloff to exacerbate and has resulted in very cheap valuations within components of the preferred shares market, specifically the perpetual preferred shares," Lagopoulos said.

While noting the risk of such an interest-rate sensitive asset, Lagopoulos said the cheap valuations of perpetual preferred shares combined with the tax benefits of preferreds, which are eligible for the dividend tax credit, make them a good option for risk-tolerant clients.

Above all, Franklin Templeton's Briggs said investors have to have an appetite for experimentation in 2014, since the Fed's actions and impact are just one big guessing game.

"Crystal balls and predictions are a mug's game in 2014," Briggs said with a laugh. "My advice is to stay short until rates flatten out."