Fidelity Expert's Take on Bond Funds

03/18/2019 5:00 am EST

Focus: FUNDS

John Bonnanzio

Editor, Fidelity Monitor & Insight

Until recently, upward pressure on interest rates this year was modest. That’s the good news. The bad news is why: slowing global growth is easing inflationary pressures, suggests John Bonnanzio, editor of Fidelity Monitor & Insight.

In the U.S., where the economy is still robust, Fed chief Jerome Powell acknowledges that the economy is sending “conflicting signals.” So in the interest of doing the economy no harm, the Fed has put the brakes on further rate hikes and has altered its plans to shed its roughly $4 trillion bond portfolio.

Here’s what’s so perplexing: With the economy in the late stages of recovery, low employment and rising wages go hand-in-hand with that healthy consumer backdrop. However, U.S. inflation is a relatively tame 1.6% (for the 12 months ending January 2019).

That’s its lowest read since June 2017. And it’s well below the Fed’s long-term target of 2% inflation. Hypotheses abound as to how this can be. Some cite monetary policy, others the emergence of low-cost frontier markets, and still others credit technology and the ability to create abundance out of scarcity.

Granted, there are data warranting concern (such as a 3.1% rise in hourly compensation which is pushing home-construction costs higher). Whatever the reasons, low U.S. inflation and fourth-quarter GDP growth of 2.6% don’t typically go hand-in-hand!

While the benchmark 10-year Treasury yield jumped 10 basis points in February to 2.73%, most of that occurred in the final two days of the month amid better-than-expected (though slowing) GDP growth. Otherwise, its yield is up a more tepid 4 basis points this year.

In turn, Intermediate Treasury Index rose 0.2% this year while U.S. Bond Index (a proxy for the bond market whose holdings include governments, corporates and mortgages) is up 0.9%.

Slowing GDP growth is a powerful deflationary force. Nevertheless, Newton’s Third Law (for every action, there is an equal and opposite reaction) is alive and well. And it suggests that after years of stagnation, real (inflation-adjusted) wage growth may finally be at hand.

A tight labor market gets most of the credit. But changing political currents (the view that rising economic tides have not lifted all “boats” equally) also plays a role. For example, minimum wage work workers have been securing significant salary increases, and in the private sector, paid family leave has gained traction.

Even millions of contract workers are making strides in winning labor rights. Should this lead to higher overall inflation, and perhaps an unanticipated hike in rates, our bond outlook (and our fund ratings) would change. But for now, here’s our take on bonds:

U.S. government bonds, including Treasuries, yield less than corporates (credits) because there’s less default risk. This is also the case with most municipal bonds.

But with the U.S. economy strong and interest rates low, there’s unlikely to be a significant increase in corporate defaults this year. As such, in comparing funds of similar interest-rate risk (the measure we use is duration), we prefer credits over government bonds.

Here’s an example: Fidelity Limited Term Government (FFXSX) and Fidelity Limited Term Bond (FJRLX) have very similar rate risk (durations are 2.6 and 2.4 years, respectively). However, the former yields 2.16% whereas the latter yields 2.89%.

And, while we’re on the subject, Fidelity Limited Term Muni Income (FSTFX) has a duration of 2.8 years and yields 1.62%. However, because the fund’s income is federally tax-free (and in some places, may be partially free of state and local taxes, too), its tax equivalent yield is substantially higher: roughly 2.1% for investors in the 22% tax bracket but as much as 2.74% for top (37%) bracket investors.

As noted, interest-rate-risk may be transient this year. On the shorter end of the yield curve, it’s clear for the time-being that the Fed has no plans to raise rates until such time that it can do so without fear that it (with the help of the global slowdown) will throw the U.S. economy into a recession. As such, the very short Fidelity Conservative Income Bond (FCONX) is rated Buy.

Fidelity Short-Term Bond (FSHBX) and other moderately low-duration funds are rated OK to Buy. As well, we’re pretty comfortable with intermediate funds such as those mentioned above, and for those who can handle more rate-risk, Fidelity Intermediate Bond (FTHRX) and the like will also serve you well.

Where we are apprehensive is with Fidelity Inflation-Protected Index (FIPDX) — it may make sense in the future, but not right now — whereas Fidelity Long-Term Treasury Index (FNBGX) is almost as volatile (risky) as a stock fund with far less upside potential.

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