The past couple of years have seen a number of commentators call the end of the multi-decade bull run in bonds but fixed-income investors are going into 2015 in the belief that opportunities can still be found, despite interest rate rises looming on the horizon.
However, one prominent bond investor - Bill Gross, who recently moved from running the world’s largest bond fund at Pimco to join Janus Capital - is much less positive and believes now could be the time for investors to take some of their profits.
The performance of bonds across 2014 surprised many investors as most expected yields to rise as the UK and US central banks moved closer to their first interest rate increases in years and the global economy strengthened. However, the reverse happened.
After starting the year at close to 3 per cent, the yield on 10-year gilts has rallied to around the 1.80 per cent mark today. Bond funds have fared well in this environment, with the below graph showing that all the main UK fixed income sectors apart from high yield have exceeded the lacklustre gains of the FTSE All Share.
Performance of sectors vs index over 2014
Source: FE Analytics
But these strong gains make it unlikely that a repeat performance will come about in 2015, while Federal Reserve and Bank of England’s expected rate rise cast a long shadow over fixed income markets. So should investors be avoiding bond funds?
Ian Spreadbury (pictured), manager of the Fidelity Strategic Bond and Fidelity MoneyBuilder Income funds thinks not as the search for yield continues, although he understands why some investors might be cautious on his asset class. 
“Is this the end of the longstanding bond bull market? The sheer level of global debt is driving a propensity to save, reducing aggregate demand and keeping inflation subdued,” he said.
“My base case for 2015 remains an economic backdrop characterised by low inflation/low growth – nominal growth could well fall further in my view, driving bond yields through current lows. I remain convinced that any interest rate hikes will be gradual in nature and supportive of bond markets.”
“I also believe the income and diversification benefits duration provide still outweigh the potential for capital loss from rising yields.”
Spreadbury believes high quality corporate bonds still offer a decent yield pick up over government bonds and points out that they offer a hedge against equities, which some forecasters expect to have another difficult year.
Jim Leaviss, head of retail fixed interest for M&G, also thinks predictions of a bear market in bonds are overdone, highlighting continued stimulus from central banks.
While the UK and US look set to tighten policy, the Bank of Japan has embarked on an ambitious quantitative easing (QE) programme while the European Central Bank is widely expected to start full-blown QE next year.
Leaviss said: “As the experience of the past few years has aptly demonstrated, making bold predictions for bond markets for the coming year requires no small measure of bravery.
“Nevertheless, with substantial volumes of QE still on the horizon in a number of globally significant economies such as Japan and the eurozone, the prospect of deflation rather than inflation keeping central bankers awake at night, and the timing of interest rate hikes being pushed out in nearly all economies, it does not need a huge leap of faith to say that conditions for bond investors currently look relatively benign.”
“Equally, as the start to 2014 showed, all it takes is a few stormy months – literally or figuratively – for all best estimates to fall by the wayside.”
Chris Iggo, chief investment officer and head of fixed income Europe and Asia at AXA Investment Managers, says pockets of value have opened up in high yield bonds and emerging market debt, which have underperformed this year as investors became wary on risk assets.
As the graph below shows, the average fund in the IMA Global Emerging Market Bond and IMA Sterling High Yield sectors have made less than 4 per cent this year. The best performing bond sector - IMA Sterling Index-Linked Gilts - has made just under 18 per cent, in contrast.
“It’s currently a very volatile period for fixed income markets with severe weakness in high yield and emerging market sectors.”
“Much of this weakness has been driven by the collapse in oil prices and the direct impact of that on cash-flow expectations for companies that have HY debt (mostly in the US) and countries that are oil producers (Russia and Venezuela),” Iggo said.
“For much of the first two thirds of 2014 we were of the view that fixed income as a whole was expensive and that there were few obvious value opportunities in a market that was dominated by central bank liquidity provision.”
“That is not the case today as high yield and emerging market credit spreads have widened significantly, particularly in the last couple of weeks, while core government bond yields have traded lower despite the potential for improved global economic growth as we head into 2015.”
Iggo’s “tentative” forecasts are that US and European high yield, European peripherals and hard currency emerging market debt will offer the best returns in 2015, as risk aversion and “awful” liquidity are creating attractive entry points into this parts of the markets.
Tom Becket (pictured), chief investment officer at Psigma Investment Management, agrees that developed market government bonds appear to be expensive at the moment, but says some areas of the market are worth looking at.
“There is little doubt that developed world sovereign bonds present a poor investment case now, following the recent rise in prices and fall in yields, although with little or no future inflation expected, one can buy inflation insurance at moderate prices in the inflation-linked markets.”
Becket is more excited by the corporate bond space and specialist credit markets, arguing that yields look “healthy” on a medium-term horizon while defaults are expected to remain low. Indeed, he argues that investors willing to accept short-term volatility have a “once in a cycle” opportunity in lower-rated corporate credits.
“Our fixed interest allocations currently consist of a mixture of attractively-priced inflation-linked global government bonds, high quality corporate bonds with short duration profiles and some dedicated exposure to lower quality, higher yielding credits, where we see outsized future returns, albeit with higher volatility,” he said.
However, Bill Gross presents a much more cautious view of the markets, arguing that central bankers’ policies of attempting to cure a debt crisis by printing more debt is distorting the market and runs the risk of massive problems spanning decades into the future.
“Markets are reaching the point of low return and diminishing liquidity,” Gross warned. “Investors may want to begin to take some chips off the table: raise asset quality, reduce duration, and prepare for at least a halt of asset appreciation engineered upon a false central bank premise of artificial yields, QE and the trickling down of faux wealth to the working class.”
