JC: Fixed Income Outlook: Insight for Investors Navigating the Fixed Income Markets

KEY POINTS
• We believe that corporate credit currently offers the best risk-adjusted return opportunities across the fixed-income spectrum.
• Management teams in the United States and Europe have been very careful over the past few years— balance sheets are strong, cash balances are high and free cash flow generation is healthy.
• We think sub-par GDP growth will present the biggest risk for bond investors in 2012.

Q: WHAT IS THE BIGGEST CHALLENGE BOND MANAGERS CURRENTLY FACE?
Darrell Watters: As governments around the world grind through a painful deleveraging period, we are finding headline risk a continuing challenge. The range of potential outcomes in any given situation is greater today because of governments’ limited ability to stimulate and support their economies, which makes forecasting outcomes more difficult. Corporate fundamentals generally are good, because management teams practiced very conservative balance sheet management over the past few years.
However, due to ongoing political uncertainty, visibility is limited at best. Market liquidity also has declined considerably since the 2008 financial crisis, making individual security selection even more critical.

Q: HOW DID THE WORLD CHANGE FOR BOND MANAGERS BETWEEN 2008 AND 2012? ARE YOU OPERATING DIFFERENTLY AS A RESULT OF THE FINANCIAL CRISIS?
Darrell Watters: Since the 2008 financial crisis, top-down macroeconomic investing has become more volatile and much less predictable. On the other hand, bottom-up security selection has become a more critical link in delivering risk-adjusted returns and preserving capital. Sovereign credit risk in some developed European nations exhibits emerging-market-like volatility, while certain emerging markets have become less volatile, more creditworthy borrowers.
Together, these factors bring a new urgency to understanding the interconnected nature of the global economy and its effects on not only domestic U.S. fixed-income investing, but also global credit and sovereign investing. The financial crisis itself highlights the importance of portfolio transparency (what you own) and manager accountability (why you own it), on both of which we at Janus hold ourselves to the highest standard.
We focus predominantly on cash bonds. While we do monitor credit default swap (CDS) trading for informational purposes, we are not CDS or derivative investors. Our portfolios seek to adapt to evolving opportunities, yet we have not changed our core investment philosophy or process. We continue to believe in a bottom-up, fundamentally driven investment process that focuses on risk-adjusted returns and capital preservation.

Q: WHICH FIXED INCOME SECTORS LOOK ATTRACTIVE TODAY?
Darrell Watters: We believe that corporate credit currently offers the best risk-adjusted return opportunities across the fixed income spectrum. Management teams in the United States and Europe have been very careful over the past few years—balance sheets are strong, cash balances are high and free cash flow generation continues to be very healthy.
We expect risk premiums to decline and credit spreads to tighten as a result.

Q: WHICH SEGMENTS OR ISSUERS DO YOU FIND ESPECIALLY ATTRACTIVE?
Darrell Watters: All things being equal, we are seeing reduced levels of spread volatility from issuers whose cash flows remain relatively predictable and stable in a variety of economic scenarios. For instance, we have seen certain cable companies and even energy producers—particularly those focused more on oil than natural gas—with these durable cash-flow characteristics.

Q: HOW IMPORTANT ARE CREDIT SPREADS IN EVALUATING BONDS?
Darrell Watters: Spreads on individual securities play an extremely important role in evaluating the relative value between securities when looking for the best risk/reward in each position. Given the appetite for risk in the market, we are more cognizant than ever of spreads as the market tends to overshoot on the upside and on the downside of valuation. We believe active management, particularly security selection within the corporate credit sector, may be the single most important factor in generating risk-adjusted outperformance in fixed income.

Q: ARE CREDIT RATINGS A SIGNIFICANT FACTOR IN THE CURRENT ENVIRONMENT?
Darrell Watters: We are ratings aware, but ratings agnostic. That is, ratings agencies play an important role for the markets, but from our perspective their inefficiencies provide great opportunity to add value to our portfolios.

Q: HOW DO YOU MINIMIZE THE RISK OF CREDIT DEFAULT? ARE THERE ANY NEW APPROACHES IN RISK MANAGEMENT?
Darrell Watters: By focusing our analysis on free-cash-flow generation and individual security selection, we have been able to minimize the risk of default. To my recollection, we have experienced only a single credit default event in our 25- year history.
Though there are a number of robust risk-management platforms available, we have found the integration of risk management into the daily portfolio management process to be uniquely beneficial. While not new, this integration of risk analysis into ongoing portfolio management does not appear to be commonplace in our industry.

Q: WHAT ARE THE BIGGEST THREATS AND OPPORTUNITIES FOR BOND INVESTORS IN 2012?
Darrell Watters: We believe sub-par GDP growth will present the biggest risk to bond investors in 2012. Several factors including high unemployment, stagnant income growth and high consumer debt balances at the consumer level are weighing on the demand side of the equation. Government austerity, not only in the U.S. but in Europe as well, will aggravate the slack in demand. On a positive note, it does look as though inflation has rolled over and is not an immediate threat to stability. This will allow central banks to continue low-interest-rate policies in an effort to enhance liquidity for balance sheet repair, and to stimulate real estate prices and demand for goods and services.
We continue to believe that corporate credit offers good risk-adjusted return opportunities. The past year was highly volatile for credit, yet underlying fundamentals continue to improve. Profit margins are high and companies are accumulating cash on balance sheets. Management teams in Europe and the United States are being more careful and have not been committing capital to their businesses—beyond replacement levels—as growth remains slow and uncertainty remains high. We think this will continue in 2012, fueling more free cash flow, liquidity and ultimately support for corporate credit spreads.

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