Fixed interest may face a tough year

However, the returns that we have had from a traditionally safe asset class have been extraordinary. This inevitably leads us to consider the potential for further returns in the years ahead.

Have we seen the best these markets can offer, is there enough left ‘on the table’ to pay for the risk that you take as a saver?

We expect yields to go modestly higher. This shift higher will largely be due to a strongly recovering UK GDP profile. Unemployment is falling rapidly and inflation may have reached a floor at roughly 2 per cent CPI. This improvement in the economic background has led the market to reassess how long it will be until the Bank of England raises interest rates.

Indeed, the expectations of a modest lift in yields will likely be understating the actual outturn. The last time UK GDP was trending roughly 2.5 per cent, inflation was roughly 2.5-3 per cent and gilt yields were closer to 4 per cent in late 2007 early 2008.

Optically, the figures suggest you should still be invested in sub-investment-grade (sub-IG) markets. However, once you adjust for defaults, this analysis changes somewhat and returns also look skinny. It is fair to expect default to remain at a very low 2.5 per cent for sub-IG bonds due to the amount of liquidity that is still supporting that market. So what to do?

Basically the problem child is government bonds. Yields will rise and investors face a loss in both real terms and nominal terms. So the simple answer is to limit exposure here.

If you strip the negative return from gilts out of the investment-grade expectations then you would be back in to positive territory at roughly 1.5 per cent for the full year 2014.

Low or zero duration credit funds or flexible funds that can move their duration exposure are the way to go.

Credit needs to compensate an investor for the risk of default as a starter. At the moment, that is still the case, however, the risks are rising. Leverage has been modestly increasing for investment-grade companies as they have struggled to find sales growth in Europe.

UK/US Growth will lead to greater board room confidence to back leveraged M&A transactions, which usually have negative implications for bondholders.

Lastly, as the pump of quantitative easing is switched off, the excess liquidity available in the international capital markets will wane and make it harder for lower quality companies to obtain ‘easy’ financing. All of this is happening with a background of rising yields.

So, it all sounds pretty gloomy for fixed interest as we go through the later stages of 2014 in to 2015.

The way out of this trap has to be a global and flexible approach to get the right side of these trends. For instance, while yields rise in the UK they could very well be falling in economies such as Australia and New Zealand.

Similarly, bond investors can look for companies that will do well out of transformational M&A such as sub-investment-grade companies acquired by their larger competitors as a way to get scale.

Picking the right product for your clients’ bond exposures has rarely been more important than times when you need to avoid potential pitfalls.

Luke Hickmore is a strategist, fixed income at Swip