In an attempt to stave off the impact of the financial crisis, central banks across the globe have been pumping billions into their economies via the process of quantitative easing (QE), by purchasing huge amounts of government debt and keeping interest rates extremely low.
But these asset-buying programmes have distorted fixed interest markets, as they have created an artificial demand for the asset class.
As a result, prices for gilts and overseas government debt have risen, making it very questionable whether or not they are overpriced at present.
Informed Choice managing director Martin Bamford says: “It has caused the price of gilts to rise and the yields to fall. How the fixed interest securities market will respond when QE is withdrawn and assets are sold back to the market is an unknown quantity.”
But with the global economy seemingly on the road to recovery, the prospect of an inevitable interest rate rise is looming over bondholders, which could in many cases see investors left nursing heavy losses as a result of the very close link between interest rates, gilt yields and corporate bond prices.
Chris Iggo, chief investment officer, fixed income, at Axa Investment Managers, says: “For a lot of people the biggest risk this year is that interest rates rise – or more likely interest rate expectations rise, which would be manifested in higher yields beyond the time frame covered by forward guidance. In the US, that could mean 10-year Treasury yields at 3.5 per cent, or possibly above, with 10-year gilts moving to similar levels.”
Mr Bamford notes that when interest rates rise, while the cost of government debt would fall and yields would rise, this would also feed through into corporate bond yields and prices as well. He says: “Corporate bond fund managers have seemed quite wary about the prospect of interest rate rises in the past six months or so, cutting duration exposure within their funds which should help reduce interest rate sensitivity.”
The main fixed interest investments are mostly affected by interest rate, inflationary and credit risk expectations. Safer government and investment-grade bonds are more influenced by interest rates and inflation while higher yielding bonds tend to be more sensitive to credit risk notes Justin Modray, founder of Candid Money.
He says: “Bonds with higher interest rates and/or shorter periods until redemption also tend to be more sensitive to interest rate and inflationary movements than those paying lower interest and/or have longer periods until redemption.”
For better or for worse, in the short term at least, all asset class performance looks set to be driven by central bank policies.
Bonds in general have been a particularly disappointing asset class of late, especially in the past year and investors have been hit with drastic underperformance relative to equities, especially given there has been a material sell-off in fixed interest as a result of economies gaining traction.
Twelve-month numbers show that the average global bond fund has lost 4 per cent while the typical global equity portfolio achieved a 12 per cent return.
Notably, sterling corporate bonds have endured consistent month-on-month outflows in the past year.
For those investors who believe that economies are out of danger and interest rates will rise, Mr Modray advises: “They will probably want to steer clear of government debt and the safest corporate bonds for now, otherwise they remain a sensible hedge in case global economies and/or stockmarkets hit the rocks once more.”
Philip Scott is a freelance journalist