Benchmark-reliant funds could underperform in the next five years as the fixed-income market faces greater interest-rate and credit-spread volatility, says UBS’ Brian Fehrenbach.

Brian Fehrenbach is the head of fixed-income derivative strategy and a managing director at UBS Global AM (Americas). As a manager of UBS Fixed Income Opportunities FNOAX. he answered our questions on how the portfolio reflects his inflation and interest-rate outlook and discussed the function this fund could serve in an investor’s portfolio.

He also explained the role that short positions play in the portfolio and his stance on the Treasuries market. Finally, he commented on how he gains an information edge in U.S. commercial mortgage-backed securities.

1. How worried are you about inflation, and how is that outlook reflected in the portfolio? Also, how are you currently positioned from a duration standpoint, and how does that reflect your current interest-rate outlook?

We are growing increasingly concerned about the inflation dynamic in the emerging markets, but less so in developed markets such as the U.S. Many global fixed-income markets have negative real interest rates, and historically, negative real interest rates have tended to lead to higher inflation rates. In our opinion, nominal bonds in some global markets do not offer much real value. In some emerging-markets economies, we expect that policymakers will have to bring higher inflationary pressures in their countries under control by tightening policy (raising interest rates) and/or allowing their currencies to appreciate. We have exhibited this in our portfolios by owning inflation-linked bonds in certain emerging-markets countries and having outright currency exposure to countries where we expect higher currency values over the near to intermediate term.

In the U.S. inflation rates seem to have bottomed and are generally trending higher. Inflation expectations, as measured by Treasury Inflation Protected Securities, have risen and are nearer to the long-term averages, but the U.S. has an output gap that will not be closed quickly given the relatively high rate of unemployment. Although the U.S. is increasingly affected by imported-goods inflation, particularly rising energy costs, we do not see the context for an imminent inflation boom fueled by a wage-price spiral. Right now, our focus is on how recently higher headline inflation rates and the correspondingly higher nominal spending on food and energy will affect the composition of consumption in the second half of 2011. In our view, higher food and gas prices might be a drag on consumption (excluding food and gas) in the second half of the year but not enough to derail the moderate economic growth expectations for the remainder of the year.

We do constrain the interest-rate management to negative five years to plus five years, at any given time. Over a full market cycle, we would expect that duration will generally average around zero. In essence, we are unbiased to being net long or net short duration. If we are (are not) being compensated for duration risk, we will (will not) own duration.

We look at duration across global markets—developed versus emerging—and within global markets—Japan versus the U.S. for example. So, we might choose to be long duration in one market and short duration in another. How that rolls up in a portfolio context can lead to a net negative or net positive portfolio position, but the risk positioning is more market-specific than what the overall portfolio value might suggest. Thus, in a broad sense, we are more neutral to duration risk in the U.S. while in Japan, for example, we are net negative duration. We do actively and tactically manage duration, so our current positioning can, and has, changed rather quickly and meaningfully.

2. Is UBS Fixed Income Opportunities designed to be a stand-alone core bond fund that will protect against inflation on an as-needed basis, or is your expectation that investors will combine it with a dedicated inflation-protected bond fund? How should investors use a fund like this within their portfolios? Should they augment it with a core bond position, or is it meant to replace such a position?

This fund is not designed to be a specific hedge for inflation; it is designed to seek a total return through a market cycle. We have the flexibility to be net short duration to protect against rising interest rates that are often associated with increasing inflation expectations. We currently own some inflation-linked bonds and can employ inflation derivatives. In a general sense, however, we are seeking compensated risks. In our view, nominal and real rates in many markets do not offer compelling value. As a result, we have been minimizing or shorting these exposures, and we expect to continue to do so.

Fixed Income Opportunities should serve as a complement to an investor’s total portfolio fixed-income allocation. That is, we would not necessarily suggest that any opportunistic and unconstrained investment strategy should fully replace a core bond allocation. But for some component of a client’s fixed-income allocation, this opportunistic and unconstrained strategy might provide good diversification and lower correlation to the traditional drivers of fixed-income portfolio performance, such as declining interest rates and tightening credit spreads.