Insight: A tough task awaits global bond funds

Insight: A tough task awaits global bond funds

The performance of global bond funds has exceeded expectations in recent years, with low inflation and even lower interest rates in regions like the US, the UK and continental Europe helping to take a decades-long bull market to new heights.

The launch quantitative easing (QE) programmes, in which the purchasing of bonds by central banks results in a boost to their value, has also aided fixed income returns in those regions and Japan.

But the largely positive news for global bonds is not expected to last into 2017. A large factor behind this anticipated change is the maturing of the economic cycle in the US. The US Federal Reserve raised interest rates in December for the second year in succession, and at least two further hikes are expected this year.

This matters for fixed income investors worldwide, because government bonds issued by countries such as the UK tend to closely track the performance of US sovereign debt.

The UK is some way away from raising interest rates – the Bank of England went the other way last August and cut the base rate to 0.25 per cent in a disputed move following the Brexit vote. But the expectation of less accommodative policy in the US has had an impact on gilts nonetheless. Ten-year UK gilt yields have risen from a record low of 0.5 per cent in August to 1.3 per cent as of last month, and reached 1.5 per cent in January 2017.

Admittedly, this move only took yields back to where they were at the start of last year. However, the arrival of US president Donald Trump has got many bond investors nervous. A fiscal stimulus programme of the kind proposed by the new administration is rarely attempted at a time of relatively healthy GDP growth. Its implementation could cause inflation levels to jump higher, hurting bonds further in the process.

Higher inflation is already starting to emerge in the UK, where the weakening of the pound has already prompted a rise in prices. The UK is also among those countries shifting away from austerity in favour of fiscal stimulus. These initiatives could be funded by greater borrowing, which could also weigh on bonds.

Set against these headwinds are structural factors, such as pension funds’ demand for fixed income, as well as a sense of déjà vu: market commentators have predicted the end for bonds almost every year for the past half decade.

Yet fixed income has continued to flourish. Even investors in European government bonds, caught up in the European sovereign debt crisis of recent years, have seen a significant rally in their holdings since European Central Bank (ECB) president Mario Draghi’s infamous “whatever it takes” speech in 2012.

High yield

Global bond funds’ success is not just down to government bond prices. They have also been helped by the performance of credit – debt issued by companies – particularly of the high-yield variety. These bonds, so called because their elevated yields compensate investors for the greater levels of risk involved, have been particular beneficiaries of the era of QE and investors’ constant demand for income.