The outlook for fixed income in the U.S. and internationally will depend, in part, on how Europe copes with its ongoing debt crisis, and how states work through pension obligations and state and local tax shortages due to the financial crisis.
"Will Spain and Portugal be forced to guarantee their bank liabilities?" asks T. Rowe Price Vice President and Chief Economist Alan Levenson (left). In particular, he is concerned with "money market funds and sovereign debt. If Portugal's and Spain's banks [have] lending-funding trouble," he said at a breakfast for media in early December, this could bleed "into U.S. money market funds." That's because they are held by "core" European banks, which are a "significant asset class for U.S. money market funds."
Levinson had some concern about this scenario: If "attacks on peripheral [European] banks show up as paper losses in core of Europe," they could amount to "paper losses in U.S. money market funds." This, in turn, could take us "back to forced selling [as we had in] '08." This could unfold like this: Investors "can't sell European banks, [if they've] fallen too far, so [institutions would need to] sell U.S. banks." If the "non-PIGS countries [the PIGS are Portugal, Ireland, Greece and Spain] have funding difficulties—that could be a problem in the U.S."
"Politics are entwined also, if [there are] issues with Spain; it is harder for Europe to fund because of its sheer size," according to Steven Huber(left), portfolio manager of the T. Rowe Price Strategic Income Fund.
Huber adds that "the secular decline in interest rates is at or near an end." But he also says it is "hard to make a case for [greater than] 10% returns in 2011 in any sector. As he expects "inflation to be modest," Huber stresses the "importance of looking globally for return; and non-dollar opportunities make sense."
"Volatility is our friend—[it] provides opportunity. Expect more volatility," Huber says.
Municipal Investing
Closer to home, low interest rates (until the past few weeks) and worries over bond ratings, lack of supply of insured, AAA-rated securities and tax-revenue erosion as the financial crisis continues to lower property values and spending have brought angst to muni markets and holders.
Hugh McGuirk (left), head of municipal investments for T. Rowe Price, mentions some bright spots in his 2011 outlook. For example, he argues that "the disappearance of monoline insurance has had a profound impact on the municipal bond market," but that "it remains very high quality." Of those munis in the investment-grade category, supply of AAA-rated bonds (in part because of the lack of bond insurance) has declined from over 60% of the category in 2007 to under 20% in 2010. More munis are now rated AA or A, according to McGuirk.
