Bonds have enjoyed a 30-year bull market, which a number of experts believe is on the brink of coming to an end.
The last five years have been especially strong, as factors such as the search for yield and demand for so-called safe haven assets, intensified the hunger for bonds.
As the graph below shows, demand for UK government, investment grade and high yield bonds has been high over recent years, driving down yields across the market. This picture has largely been reflected across the globe.
Performance of indices over 5yrs
Source: FE Analytics
Cielinski, head of fixed income at Threadneedle Investments, said: “Over the past five years, fixed income has provided investors with significant positive returns.”
“Government bond values have risen as market yields as a whole have fallen. Returns on corporate credits have been even higher as the difference in market yield between corporate bonds and government bonds has fallen to historically low levels.”
However, the likely interest rate rises than are coming from the UK and US central banks in the next year or so mean investors should get ready for lower returns than they have been used to in the recent past.
“Looking ahead however, prospective returns are likely to be limited by the extremely low level of yields now offered, particularly by government bonds,” Cielinski said.
“Yields are approaching zero in many markets and investors clearly cannot rely on benchmarked ‘long-only’ fixed income strategies to deliver meaningful returns.”
“Moreover, volatility is on the rise. In the second quarter of 2013, emerging market debt suffered significant falls in value and more recently there has been more volatility within the high yield market.”
Despite this outlook, the manager says opportunities to generate “meaningful returns” can be found within bond markets.
Crucial elements to this are investments that will generate alpha independent of beta and portfolio diversification.
“With the right approach and strategy, it is possible to deliver sustainable risk-adjusted returns even in changing market conditions,” he said.
“One of the biggest mistakes that investors can make in fixed income is to rely on one or two large, directional macro calls, as these are notoriously difficult to get right. The cost of getting it wrong can be further amplified by liquidity problems.”
In his Threadneedle (Lux) Global Opportunities Bond fund, Cielinski has been pursuing a number of strategies that will allow it to take advantage of rising yields or widening credit spreads.
One of these is a long position in high yield bonds that is hedged by a short position in investment grade bonds.
Currency is also another way for bond fund managers to add value in the current environment.
The manager is currently long the US dollar versus a range of other currencies but has recently been buying local debt of high-quality markets such as Mexico and Colombia.
Performance of fund vs sector since launch
Source: FE Analytics
Fraser Lundie and Mitch Reznick, co-heads of credit at Hermes, agree that careful navigation will be needed over the coming months to generate returns from fixed income.
“Security selection has rarely been more vital. Lower valuations and diminished extension risk, which followed a signi?cant summer re-pricing, provide better stock-picking opportunities. This said, the ‘?xed income’ risks to credit are heightened,” they said.
“Both duration and convexity risk remain signi?cant for large parts of the credit market, given the impending normalisation of US Federal Reserve monetary policy and the large execution risks associated with this. Secondary market illiquidity – a situation fuelled by regulator restrictions of banks holding inventory and therefore providing liquidity to an over-concentrated buy side – may exacerbate such risks.”
They predict that key to outperformance by bond funds in the future will be “paying the right price for the right securities”, adding that choosing the correct bonds with issuers’ capital structures will be vital to success.
Russ Koesterich, global chief investment strategist at BlackRock, warns that low bond yields and the ongoing “thirst” for income could be pushing investors in more expensive parts of the equity market and take on “hidden risks”.
An example of this, he says, is the strong appetite for defensive stocks with low volatility and a high dividend yield, such as consumer staples and utilities.
Real estate investment trusts are another beneficiary of this trend.
But Koesterich said: “The defensive sectors all sport aggressive valuations and carry hidden duration, or interest rate sensitivity. If interest rates rise even modestly in 2015 - as we expect they will - these sectors are likely to perform poorly, as their valuations are particularly sensitive to rate rises.”
“Instead of taking on more exposure to these parts of the market, we would prefer to source our yield from other places, including high yield bonds and more cyclical sectors of the equity market, which could be poised to benefit from an improving economy.”
