Bond fortunes in the balance as riskier credit continues to soar

Figures from the Investment Association show the asset class experienced a reversal of fortune last year, recording net retail sales of £3.8bn compared with net retail outflows of £2.1bn in 2015, while equities recorded £8.2bn of outflows in 2016 against the £7.8bn of inflows the previous year. Is this trend likely to continue into 2017?

Steven Oh, global head of credit and fixed income at PineBridge, notes: “With political risk and a transitory environment of monetary and fiscal policy we can expect volatility to impact investing in fixed income. Investors must capture incremental alpha opportunities both across and within asset classes through micro views and security selection.”

If yields move up rapidly to give the impression the bond market is poorly supported, outflows could be a risk

As an example, he suggests that in developed markets investment grade, US dollar credit is preferred over European credit, with Treasury Inflation-Protected Securities as a defensive portfolio hedge, given higher US inflation risk. 

Peter Bentley, head of UK and global credit at Insight Investment, adds: “US dollar credit indices ended 2016 trading around their narrowest credit spreads of the year, and ahead of sterling and euro credit on an excess return basis. Following Donald Trump’s win in November, risk markets initially sold off. But this reversed on the likelihood of a fiscal spending programme, corporate tax cuts and a more lax regulatory environment. Yield buyers, attracted by a sell-off in treasuries, offered further support to US credit. We have a positive view towards investment grade, particularly in the US, given the demand from long-dated yield buyers. But if yields move up rapidly to give the impression the bond market is poorly supported, outflows could be a risk.”

On this side of the Atlantic, Mr Bentley suggests the recent underperformance of sterling credit, in spite of “aggressive direct support from the Bank of England”, has left the market looking more attractive. 

“Euro credit, which underperformed towards the end of the year, offers less tactical value, in our view. From a sector perspective, we favour European banks. While we expect concerns surrounding the Italian banks to remain contained, we are mindful of political risks in 2017.” 

Those political risks include the triggering of Article 50 in the UK, and elections in France, the Netherlands and Germany. 

But Nick Gartside, chief investment officer, fixed income, at JP Morgan Asset Management, says: “Despite the potential for further political noise, market volatility is conspicuous by its absence. The Vix index is trending close to all-time low levels. Fundamental data is robust across the globe. Political risk remains the principal headwind. The focus has now shifted to Europe’s political calendar, leading to a sell-off in French and peripheral European bond yields.”

He explains an ongoing improvement in global economic data has produced strong performance for risk assets and investors have responded by buying risk sectors, such as emerging market debt and US high yield. As such, it may be time to take a more cautious approach. 

“Although spreads still have scope to tighten given the strength of the fundamental backdrop, this low-volatility, positive-momentum environment provides an attractive entry point to add some portfolio hedges,” he says. “With elections coming up, and the UK set to trigger Article 50, implementing cost-effective hedges now could help investors protect portfolios from the likely return of volatility to more ‘normal’ levels.” 

Nyree Stewart is features editor at Investment Adviser