Testing the safety of the fixed income haven

Yet this is a view being pushed to its limit in 2016. Propelled upwards by looser central bank policy, bond returns have become a function not so much of fundamental credit analysis, but the monetary policy outlook.

For investors, government bonds now offer an increasingly asymmetric risk profile. Negative yields imply that investors can only generate a return if they can sell the bond for an increase in its capital value; essentially representing a reliance on economic conditions deteriorating.

At the same time, any capital gains achieved are vulnerable to sharp reversals in investor sentiment on monetary policy, such as with the sell-off in Japanese government bonds over the summer.

Of course, individual markets also bring their own complications, such as with UK government debt.

With a quarter point rate cut and an additional £60bn in bond buying announced, easing from the Bank of England after the Brexit vote was enough to push UK government yields down.

The yield on UK 10-year debt even turned negative (briefly) in absolute terms, as UK CPI inflation rose to 0.6 per cent in the year to July. Yet it remains an open question as to whether to trust UK government yields to fall further, with the UK having to finance twin current account and fiscal deficits as well as the weakened pound having diminished the gains for foreign investors’ non-hedged UK gilts holdings.

Outside government bonds, however, there continue to be opportunities for multi-asset investors within fixed income, most notably in US and European high yield and local currency emerging market debt. These areas, together with non-traditional opportunities such as infrastructure, can help investors generate a sustainable income, even in the context of record low rates. 

Across the three major regions, high yield bonds have performed strongly since their February lows.

While there were concerns about the energy sector, portfolio managers at Fidelity Solutions felt these were actually being excessively priced in, with fears over the oil price contaminating the wider high yield index. US high yield has since seen strong returns, supported by the fundamental strength of the US economy and the favourable maturity wall of the asset class (see Chart 1), with comparatively few companies needing to refinance in 2016. More recently, however, Fidelity Solutions has begun to take profits after strong performance. 

Some managers have rotated the US high yield exposure into European high yield, which should benefit from the continued loose policy of the ECB and its purchases of investment grade bonds. European growth has held up well over the past 18 months or so, and while there may be some impact from the Brexit result, European high yield represents a safer means to play a continued European recovery than European equities. Relative to US and European high yield, Asian high yield is now less attractive, as spreads in the former have re-priced and the latter faces a significantly steeper maturity wall.

In general, Asian assets have performed well in the wake of the Brexit vote, and this is likely to continue as investors redirect flows away from the UK and Europe. Asian bonds, for example, currently offer an attractive yield of about 4 per cent from an investment grade perspective.

I also like local currency emerging market debt, which offers a relatively attractive yield in a world of low rates overall. The scale of emerging market (EM) currency depreciation seen thus far offers some protection going forward, with signs that EM currencies have reached (or are close to) a bottom. It may be that in a yield hungry world, EM currencies simply cannot push much lower, particularly with the Fed having proven to be more dovish than many expected.

Going forward, much depends on the economic fundamentals of the EM complex. While falling inflation could lead to gains in the capital value of EM bonds, Fidelity Solutions remains happy for now to add on weakness, considering the still fragile nature of many EM economies. Within hard currency exposure, sovereign and corporate dollar spreads do not look to have responded sufficiently to weak economic fundamentals. 

Of course, one of the big surprises for many fixed income investors in 2016 has been the marked dovishness of the Fed. While they were signalling for four rate rises at the beginning of 2016, we are now likely to see just a solitary hike in December (with the Fed having also lowered its estimates of the terminal rate in 2016).

This is despite inflation being likely to rise above the Fed’s target on the back of higher commodity prices and base effects. This poses a dilemma for fixed income investors; whether to position for higher inflation now, or to see inflation as a temporary phenomenon that the Fed is likely to look through. As inflation protection remains cheap, at Fidelity Solutions we think a diversified portfolio across nominal and real (inflation linked) bonds makes sense at this stage of the economic cycle. This is particularly the case in the UK, where at we believe markets are underestimating the impact of sterling depreciation on driving up inflation. 

Multi-asset investors can therefore continue to benefit from a fixed income allocation, with opportunities in local currency emerging market debt and individual high yield regions. However, investors still need to be mindful of the challenges that fixed income brings in a low yield world, with asymmetric risks around government bonds continuing to pose difficulties, as well as the outlook for interest rate policy and the future path of inflation. As investor sentiment on monetary policy shifts, fixed income investors will need to be nimble in assessing where the best balance of risk and reward lies. 

George Efstathopoulos is portfolio manager of Fidelity Solutions