Fixed IncomeJan 26 2015

Investors may need to curb expectations

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by

For many investors, this means that fixed income will be under pressure in 2015 and that they will have to lower their expectations in terms of returns from these types of assets.

Ben Bennett, credit strategist at Legal & General Investment Management (LGIM), suggests that investors’ expectations for 2014 fixed income markets were proved wrong early on in the year.

He notes: “It will take a little while for people to work out what that means for 2015. What I’m still hearing from quite a few sell-side investment banks that this year is when we’re going to see the increase in growth, interest rates will start to go up and it will be what we thought 2014 would be but delayed by a year.”

He questions the view that the worst-case scenario for fixed income will be a rise in interest rates by UK and US central banks.

“When discussing fixed income and headwinds, most people still believe the worst thing for fixed income is for interest rates to rise; that’s because it’s been ingrained in their minds for the past couple of years that we will, at some point, get higher interest rates because we’re going to get normalised policy,” he says.

“That, for me, is the benign base case. Yes, the total returns are not going to be great but they’re going to be okay. My downside for fixed income is the realisation that we’re in a deeper, long-term hole, which would be even worse for things like equity markets.

“The only reason why fixed income is bad under that scenario is because you have higher credit spreads,” he adds.

“If you just buy government bonds, that’s great as you lock in those lower interest rates. But if you buy anything in corporate bonds you get wider spreads, and that undermines your total return.”

Nevertheless, an announcement by US Federal Reserve chairwoman Janet Yellen signalling a return to normal monetary policy will have some impact on fixed income, so investors should be aware of the outlook should this happen later in the year.

David Kelly, chief global strategist at JPMorgan Asset Management, in a note on how to invest in fixed income this year, advises that once the Federal Reserve begins hiking interest rates – possibly around June – it will continue to do so at subsequent meetings in order to reach its long-term target of 3.75 per cent by 2017.

He says: “Such a scenario implies negative total returns along the entire Treasury yield curve for maturities of two years and above during 2015. Consequently, this should be a year to be underweight Treasuries and short duration in the US.

“Treasury inflation-protected securities are also likely to provide negative returns in 2015 since the increase in nominal Treasury yields is likely to come from higher real yields rather than higher inflation.”

Mr Kelly forecasts that corporate bonds will outperform Treasuries in an improving US economy with rising Treasury rates. But he believes bond markets outside the US look attractive too.

“Recent announcements from the Bank of Japan and the European Central Bank confirm the determination of these central banks to provide further monetary stimulus, and neither Japan nor Europe are showing signs of much economic growth or inflation,” he notes.

“We favour the higher yields available on European debt [versus] Japanese government bonds. Peripheral European debt, however, could be vulnerable to renewed concerns over credit worries.”

Turning his attention to Asia, Mr Kelly suggests emerging market bonds are offering higher yields than their developed market counterparts. He says countries with “strong” central banks – those that are protecting their currencies and “subduing” inflation, such as India – will offer relatively good returns to investors.

Jon Jonsson, manager of the Neuberger Berman Global Bond Absolute Return fund, explains the reasons behind his “strong view” that duration risk is looking overpriced.

He notes: “With oil prices continuing to decline and inflation expectations falling, people are questioning the global growth environment. We could see yields drop further from here, but ultimately we think the duration risk is overpriced.

“We think less duration and more credit risk is a better composition in your fixed income portfolio at this point.”

Ellie Duncan is deputy features editor at Investment Adviser

Expert view

Chris Higham, manager of the Aviva Investors Strategic Bond fund, comments on the outlook for fixed income in 2015:

“We remain constructive on fixed income assets in 2015 as we expect yields to continue to remain low across the globe. Bond markets are expected to receive further monetary policy support from central banks in both Europe and Japan as they try to boost inflation expectations. Global growth is likely to remain subdued, while there remain numerous risks for markets in the form of geopolitics, energy and the Chinese property market.

“Recent market volatility has, however, presented numerous opportunities within fixed income. For example, emerging market credit spreads are now back at their highest level for five years at 450 basis points – equating to a 6.5 per cent yield.

“The US high-yield market is also yielding approximately 7 per cent, due to its high level of exposure to energy-related credits. The cost of insuring portfolios against future levels of inflation has become significantly more attractive than at any point in the past few years.

“We continue to assess these opportunities but appreciate that we very much remain in unchartered territory in terms of the global economy. It is important to be selective and we fully expect stock selection to continue to be the main driver of returns in 2015.”