Better Bond Market Expected Next Year: Schwab's Kathy Jones

She also recommends that U.S. bond investors “move up in credit quality, especially in corporate bonds,” because investors “aren’t being compensated to take on much credit risk,” and that they “stay close to home,” buying U.S. dollar-denominated debt because the currency will stay strong.

Finally, Jones suggests that U.S. bond investors “play defense with diversification and liquidity” because liquidity is declining in U.S. and global markets as central banks retreat from accommodative easing policies.

“When liquidity goes out,  volatility increases, risk spreads increase and there is a divergence in performance,” says Jones.

Schwab is neutral on investment grade and high yield bonds — investors are not compensated enough for risk if the economy starts to deteriorate, says Jones — and underweight emerging market bonds in large part because a strong dollar hurts many sovereign issuers whose debt is denominated in the greenback.

Jones likes preferred securities with “fat coupons” when their prices are cheap, but cautions that retail investors shouldn’t buy these securities on their own due to that market’s idiosyncratic behavior.

She’s also likes investment-grade floating rate debt whose payments reset when rates rise, preferring them to bank loans, which have more credit risk. “There’s still room to buy floaters so long as the Fed tightens,” says Jones.

Muni bonds are another bond asset Jones likes in the current market. Supplies have been held in check and demand is strong, especially among high-net-worth investors living in high-tax states, says Jones. Given the $10,000 cap on state and local tax deductions enacted in the big tax cut legislation, those investors are looking for other tax-advantaged investments.

— Check out Expect Fewer Recessions but Weaker Recoveries: J.P. Morgan on ThinkAdvisor.