How moderate risk is likely to perform

According to Adrian Hull, senior fixed income product specialist for Kames Capital, there are events on the horizon that could dampen expectations but he believes there is still a case for solid returns from fixed income.

He explains there has been approximately a one-third increase in sensitivity of global bond markets to interest rates over the past five years, most of which has happened in the last two years, and investors have received "extraordinary returns from fixed income markets materially in excess of stable coupons".

However, he believes this is now over, stating: "As markets have priced the effects of central banks' action, and the deflationary effects of the global financial crisis and euro crisis, expectations of these returns [in the future] are unrealistic.

"But there is a good case to see solid returns from fixed income, and indeed moderate returns," he commented.

Investors are increasingly in need of income, and this will put a lid on how far yields will rise. Adrian Lowcock

Others also believe that while high single-digit to low double-digit yields from moderate-risk, well-diversified fixed income funds may be a thing of the past, investors can still expect to do well out of fixed income. 

George Efstathopoulos, multi-asset portfolio manager for Fidelity International, agrees the days of "good yield for moderate risk are not over in fixed income, although we face a challenging environment".

He explains: "This is the case not only if you compare yield levels before and after the financial crisis, but also if you look at yields today compared with their levels in recent years.

"You could obtain a very attractive income from US high yield a year ago, for example."

Disparity and performance

According to Mr Efstathopoulos, there seems to be a disparity between government yields and credit yields over the past few months.

He comments: "The interesting thing about the recent moves in yields is we have seen tighter spreads as government yields rise, while credit yields remain broadly where they are.

"For fixed income investors, this is possibly the worst of both worlds, with lower yielding debt threatened by inflation, and credit not offering compensation for the risk involved."

But even so, he does not think the days of decent yield in moderate risk fixed income are gone.

Mr Efstathopoulos adds: "There are still areas which offer a good level of yield and which have the potential to outperform."

He lists some of these areas as: 

• financial debt.
• local currency emerging market debt.
• leveraged loans.

And in pure performance terms, UK investors buying bond funds back in 2006 - just as the collateralised debt obligation geniuses at US investment banks were about to precipitate the world into a global debt crisis - will have done spectacularly well over the decade.

Income payments aside, investors holding onto an Investment Association Global Bond Sector fund will have, on average, seen an average 91.7 per cent return on their holdings - only slightly lower than its global equity cousin, the IA Global sector, which enjoyed an average 98.9 per cent growth.

While nowhere near as high as the average global bond fund, sterling-denominated sectors (UK Gilts, High Yield, Corporate Bond and so on) have also delivered in terms of performance change over the past decade (see Table 1, below).

Lower hopes

Not everyone is sanguine about fixed income.

Ashish Shah and Scott DiMaggio of AB (formerly known as Alliance Bernstein) warn that an average passively managed 'diversified' global bond portfolio hasn't delivered in terms of yield, when inflation is taken into account.

They suggest investors in such funds may find themselves on the wrong side of inflation duration when interest rates rise. Duration and inflation exposure is covered in the fourth article in this guide.

Adrian Lowcock, investment director at Architas, is also less convinced about the prospects for fixed income - and thinks returns from fixed income have not been that rosy for a while.

He thinks "good yield" hasn't really been around for a few years, despite a few blips throughout 2016 when sovereign debt sell-offs, thanks in part to central bank policies and political events, caused yields to rise - if you can call a 13 basis point rise to a 1.38 per cent post-EU referendum "high" for UK gilts a 'rise' worth mentioning.

Mr Lowcock explains: "I'm not sure good yield has been around for a few years now.

"While yields have recovered from their lows seen in the midst of 2016, the bond bubble is only likely to deflate (but not burst).

"We are not going to go back to the pre-crisis levels. 

"That said, we may have reached a maximum level [for moderate risk in fixed income] but the market is still going to demand an income. Investors are increasingly in need of income, and this will put a lid on how far yields will rise."

Again, looking past the yield payments and taking into account pure percentage performance, the Investment Association statistics do not present a pretty picture for either equities or bond funds.

It will be no surprise that UK gilts and corporates in particular have taken a hammering in the short-term, with Brexit talk, global uncertainty and ever-dovish signals from the Bank of England helping to maintain some bond gloom.

Table 1: IA sector performance (%age change, to 31 October 2016, according to Morningstar)

Mr Lowcock's comments are echoed by those of Patrick Connolly, certified financial planner for Chase de Vere, who says: "What people consider to be a good yield is relative.

"We need to appreciate that we are in a low interest rate environment, we have been for some time and there is every indication we will be in such an environment for some time to come.

"This needs to be reflected in clients' expectations in terms of the level of income they can achieve, and the amount of risk they will have to take to generate it."

Trumponomics and deflation

As the world gears up to see what a Donald Trump presidency will bring after his inauguration on 20 January, the expected "game changers" in terms of economic policies may have some dampening effects on fixed income, but much of this has already been priced in.

This is the view of Kames Capital's Mr Hull, who adds: "Markets have already priced in a lot of expectations of his policies, but many of the deflation trends remain. 

"That said, moderate risks and returns are still achievable from fixed income."

Aviva Investors believes the global growth outlook is supportive of higher inflation.

It expects the global economy to expand in 2017 and 2018 at its fastest pace since 2011, particularly if other countries join the US in the adoption of more expansive fiscal policy.

Ian Pizer, head of investment strategy for Aviva Investors, says: "Significant tax reform is a potential game-changer in the US and would support developed market equities in 2017, with increased infrastructure spending boosting industrials and materials.

"The upward trend in global yields will continue, helping US and European financials, although central bank policies in the euro area and Japan could lead to an increasingly differentiated outlook versus the US.

"Central bank purchases should sustain corporate bond markets, where spreads remain attractive relative to valuations in other asset classes."

simoney.kyriakou@ft.com