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While bonds have fallen out of favor in recent months it’s important to remember the purpose that bonds serve in a portfolio – to diversify the inherent risk of the equity portion of a portfolio.  This morning Neuberger Berman released a succinct, but excellent overview of the fixed income markets for the upcoming year:

“Against a backdrop of positive economic growth and low inflation, our outlook is for the spread sectors to continue to outperform equal-duration Treasuries in 2011. We also envision spread narrowing amid an environment characterized by overall strong investor demand. That said, spread sector excess returns versus Treasuries are not likely to be as large as during the past 2 years

Investment Grade Credit

As of early December, it appears that investment grade bonds are on track for another year of solid results in 2011. Looking forward, we believe that many of the factors that supported the credit market in 2009 and 2010 remain in place heading into 2011. These include strong corporate balance sheets, improving corporate profits, attractive borrowing costs and robust demand given the low interest rate environment. We also anticipate a further decline in corporate defaults.

Even with their strong performance since the height of the credit crisis, investment grade bond valuations, in our opinion, remain compelling from a historical perspective. With improving fundamentals and solid supply / demand characteristics, additional – although more moderate – spread tightening in 2011 appears likely. From a sector perspective, we find industrials to be the most attractive sector as the economy regains its footing. We also believe that financials have attractive risk-adjusted return potential given continued low interest rates and our expectations for improving profit margins.

Agencies, Residential Mortgage-Backed Securities

In mid-2010, we found agency mortgage-backed securities (MBS) to be relatively unattractive given the conclusion of the Fed’s purchasing program of the securities, which was tied to the first round of quantitative easing. In particular, we found their valuations to be rich and had concerns about who would replace the government as the marginal buyer. 6 months later, we believe that agency MBS are more fairly valued, especially versus other investment grade spread sectors. In addition, we think prepayment risks are not as significant as before, given the number of mortgages that are underwater as a result of the sharp decline in housing prices. We believe spread tightening particularly in the second half of 2011 is a possibility as interest rates trend somewhat higher and investor demand for agency MBS increases.

In our opinion, non-agency residential mortgage-backed securities (RMBS) continue to offer attractive loss-adjusted yields, although the bulk of the price rally appears to be behind us. Demand from individual investors, corporations and public-private investment program managers may remain solid and, as such, we have a positive outlook for the sector in 2011.

Asset-Backed Securities

Asset-Backed Securities (ABS) appear likely to underperform most spread sectors in 2010. While more issuance in the ABS market has helped increase liquidity, credit card and auto ABS offer marginal relative value. Looking ahead to 2011, primarily due to their short duration, the yield premium offered by ABS does not appear to present better that a break-even outlook on a risk-adjusted basis.

Commercial Mortgage-Backed Securities

For much of 2010, commercial mortgage-backed securities (CMBS) have produced what we consider outstanding results. The sector has been supported by attractive spreads and strong investor demand given their relatively high yields. While we believe CMBS spreads are currently reasonable, the majority of spread tightening appears to have already occurred. In addition, fundamentals in the commercial property markets remain weak and this could contribute to price volatility within the CMBS sector in the coming year.

Treasury Inflation-ProtectedSecurities

Expectations that QE2 would result in higher inflation triggered a strong rally for Treasury Inflation-Protected Securities (TIPS) from late August to late October. Despite the trend, expectations for inflation, as currently reflected in the marketplace, are below the Fed’s target and below the average historical level of approximately 2.5%. This is happening while the Fed is using unorthodox techniques to reflate the economy and as large fiscal deficits persist. The inflation risks for longer investment horizons (3–7 years) remain in place and, in our opinion, TIPS are still the most attractive high-quality option to help bond portfolios hedge against inflation in that environment. As a result, we remain modestly positive on the sector.”

Source: Neuberger Berman

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