Fixed Income  

Flexible approach will pay rewards

This article is part of
Hunt for Income - March 2015

For some time we have been told by some very smart people that bond bubbles everywhere were about to burst and that we should be running for the hills.

As we move into the latter stages of the first quarter in a year when monetary policy, in some economies at least, may finally be tightened – with, for example, 10-year US Treasuries at 2 per cent, 10-year gilts at 1.8 per cent and German bunds of the same maturity at 0.3 per cent – it is not likely to be a year of stellar returns from government bonds.

Add to this investment-grade risk premiums at their lowest level since the crisis and high-yield markets in the US and Europe offering 6 per cent and 4 per cent respectively, and returns may well be skinny.

Extremely accommodative global monetary policy, collapsing inflation and elevated geopolitical risks have all contributed to the environment, and continue to do so in the early part of 2015.

On top of this, ageing populations continue to demand income and are helping create a near unprecedented technical position where supply is failing to keep pace with demand.

The main threat seen by many comes from policy rates, which should be announced by the US Federal Reserve around the middle of the year, and the Bank of England towards the end of 2015.

A more sanguine view is that although hikes will come through the measured approach already adopted, they will persist for some time.

Some tough decisions were taken in adopting the range of policies in place, and the reversal is likely to be equally challenging. The last thing economies such as the US and the UK need is a sudden slip back towards recession caused by significantly higher yields.

Also in favour of Janet Yellen, Mark Carney and their colleagues deferring drastic measures is inflation.

Inflation has collapsed over the past two years and is expected to fall further soon. This takes the pressure off policymakers, who have less reason to make aggressive moves.

Although government bond yields are far from exciting, credit markets, investment grade in particular, do still look appealing. Risk premiums (yield spreads) have fallen materially, but can be expected to continue to do so.

Fixed income is a major beneficiary of quantitative easing (the creation of money by the relevant central bank) and the overall backdrop in financial markets. Some corporate issuers have started to re-lever, but the fundamental backdrop is still generally favourable.

Liquidity remains an issue in this asset class but careful stockpicking and diversification should hopefully generate positive returns.

With this in mind, it makes sense to adopt a flexible and diversified approach to managing bond exposure, and recognise that there are risks in both government and credit markets.

Higher yields will have a negative impact at some stage and being able to hedge this and other risks from portfolios will be crucial to preserving capital.

Luke Hickmore is senior investment manager at Aberdeen Asset Management