The distortionary impact of QE on government bond yields worldwide has been enormous. Ongoing QE in Europe, Japan and UK serves to perpetuate this. Central bank balance sheets around the world have swollen exponentially since the global financial crisis and some argue that these bloated sheets should begin to contract as and when economic conditions dictate. This is in effect the purist interpretation of how QE should work once it is deemed to have been successful. The impact on bond markets would be dramatic as vast tranches of existing government bonds returned to the open market. Potentially this could be a major component of a perfect storm that forces bond yields to rise back to more attractive levels.
On many occasions over the past few years market commentators have prematurely forecast the end of the 25-year bull market in bonds. This headline grabbing prophecy has proven to be more elusive than many seasoned observers expected. Without wishing to portray just one side of the story, there was a telling example of just how dangerous too much duration can be when bond yields rose sharply after hitting historic lows in August. Benchmark long-dated gilts fell by some 40 points (20 per cent) in a virtually straight line, displaying the kind of volatility normally reserved for certain other asset classes.
Holders of bonds have enjoyed strong total returns at times as a result of the duration effect that has benefited capital values when yields have fallen. This phenomenon is unlikely to occur in any meaningful sense in 2017, as yields remain historically extremely low. Therefore, investors would be unwise to expect a total return of much in excess of prevailing market interest rates during the year ahead. There is also a strong possibility that there will be periods of volatility that could prove to be unsettling for holders who are not fully aware of the incumbent risks.
The global outlook is extremely complex. With the forthcoming European elections and the results of the US presidential election, the political background has become very uncertain. With plenty of scope for future political shocks during the coming year, particularly in Europe, bond market investors will be wary of complacency. The rest of 2017 promises to be full of surprises and opportunities. From an asset allocation perspective there are numerous reasons why portfolios should be as well diversified as possible, because if 2016 has taught us two things it is that anything can happen and probably will, and that even if you knew the outcome of key events, your reaction may well not be the correct one.
Ian Entwisle is head of fixed interest of Rowan Dartington