Where Will Interest Rates Go in 2013?

January's backup in interest rates, nearly 25 basis points at the 10-year, makes returns to most popular fixed income strategies negative in January. Benchmark indices for most of these products, the Barclay's Aggregate Index is down nearly 80 basis points, and the average intermediate core bond fund manager is down nearly 40 basis points. These negative returns in January serve as a reminder of interest rate risk in a fixed income portfolio. We think that reminder is important as investors consider the degree of interest rate risk they're taking in their fixed income portfolios. However, we do not anticipate that this rate of increase in interest rates will persist for the remainder of 2013. Rather, our outlook forecasts only modest increases in interest rates, targeting a 2.25 percent 10-year to the end of the year. However, getting to that rate won't be in a straight line. We expect significant deviations along the way.

How should investors position their fixed income portfolios under such an interest rate outlook? The key recommendation remains that the risks for owning high duration, long maturity fixed income investments outweigh the rewards. And the investment conclusion is clear. Reduce interest rate risk in the portfolio in favor of areas of the fixed income markets that continue to compensate you for the risks that you're taking. These areas remain the credit risk components of the fixed income markets.

Shifting a portfolio from a concentration of interest rate risk to credit risk remains our main recommendation in 2013. The method in which this is best accomplished is by moving away from traditional benchmark-focused fixed income products with long durations towards flexible, unconstrained or opportunistic approaches that throw out the old style of management that benchmarks to a long duration, giving the manager a greater flexibility to asset allocate into the areas of the fixed income markets that better compensate investors for the risks that they're taking.