This year has been torrid for fixed income investors to say the least, following increased volatility, low yields and frequent sell-offs threatening to strip the asset class of its ‘safe haven’ reputation.
Global bonds showed a correlation with equities in August following concerns surrounding the China slowdown and this, combined with the building anticipation of a rate rise from the Fed throughout the year, has turned many investors pale on fixed income.
Performance of indices in 2015
Source: FE Analytics
Many have therefore wondered whether the 30-year bond bull market has finally run its course and the shadow of a liquidity squeeze hanging over the asset class has arguably been another deterrent.
Amidst the gloom though, will there be pockets of opportunity in fixed income as we head into the New Year? 
Luca Paolini (pictured), chief strategist at Pictet Asset Management, says that while growth and further quantitative easing could prove to be beneficial for riskier asset classes such as European and emerging market equities, the outlook for bonds is less clear cut.
“[Rate rises] and the growing likelihood of more monetary stimulus from both the European Central Bank and the People’s Bank of China means that ultra-easy monetary policy will continue to be a key feature of the investment landscape. Equities should therefore do well,” he said.
“Fixed income asset classes – government bonds in particular – should do less well. Even if several major central banks remain in easing mode, yields on many developed world government bonds are hovering at unjustifiably low levels, not least because inflationary pressures look likely to build as the year progresses.”
He adds that the yield difference between bunds and treasuries is heavily influenced by the difference in growth between the US and the eurozone economies and, now that this growth gap is nearly closed, he believes that the yield gap will also narrow throughout the course of next year.
AXA IM’s Chris Iggo says the divergence in performance between European fixed income assets and US fixed income tells an interesting story about monetary policy and adds that the sectors with the highest yield at the same time that the ECB embarked on QE saw the biggest benefits.
Of course, he points out that inflation-linked assets also did well as he says the whole purpose of an asset-purchasing programme is to raise inflation.
“European break-even inflation rates now stand higher than they did at the beginning of the year, thus providing an outperformance relative to nominal government bonds,” he said.
“For the US the never-ending story has been about when the Fed will raise interest rates. On top of that the high yield sector has underperformed as a result of energy, while investment grade has seen spreads widen throughout the year because of the clear re-leveraging trend amongst American companies.”
On a more general note, the chief investment officer of global fixed income says that it will remain difficult to achieve significant returns from bonds in the New Year, despite the fact that yields are slightly higher than at the end of last year.
“Any additional income return might be lost by a more negative price return, especially in markets where rates go up (US and UK),” he pointed out.
“Short duration is the way to play rising rates and in high yield any rise in defaults is likely to come after rates have gone up. So investors should be rewarded for taking credit risk. But key to all is what the Fed does, what inflation does and how the economy and the markets react.”
Fidelity’s Andrew Wells agrees that high yield is likely to be a good fixed income market play as we head into the New Year. However, he is generally more positive on the market and expects credit in general to perform strongly as the economy looks set to enter a latent stage of the cycle.
“While credit fundamentals deteriorated again this year, particularly in the US, the widening of spreads through 2015 has created valuation opportunities,” he explained.
“Indeed, spreads across asset classes are close to three-year highs. This enthusiasm applies across the credit spectrum with investment grade, high yield and EMD [emerging market debt] all ripe for recovery.”
Performance of sectors over 2015
Source: FE Analytics
Within credit though, Wells still favours high yield bonds over investment grade on an absolute return basis and he believes that local currency assets within emerging market debt could well recover.
“EM FX volatility is likely to stay elevated and recovery may be a story for the latter half of the year as investors latch onto the attractive carry as well as better signs of stabilisation and rebalancing in EM growth,” he continued.
“Esoteric classes should also fare well. Hybrids – bonds with equity-like characteristics – are one of our standout picks for 2016, owing to their combination of carry and spread-tightening potential as investors draw to a new and growing asset class.”
Phillip Apel, head of fixed income at Henderson, is also reasonably positive on the asset class, particularly when compared to how he felt this time last year. While he says that there is likely to be more volatility going forwards as a result of more defaults, he says this should create opportunities.
“In the main we are more positive, particularly away from sovereign markets. This is because the repricing of credit markets in 2015 means that yields are generally higher and spreads wider than at the start of 2015, so valuations for the medium term are at a more attractive starting point,” he said.
“We expect growth to trend in the US and Europe but to still remain challenged in emerging markets. Against that background we expect inflation to pick up towards central bank objective levels, in part because the year-on-year comparisons will see some of the sharp commodity price drops fall away. In our view, the Fed will be on a path of tightening that is somewhat faster than the market currently expects but will still be gradual compared to the historical average.”
FE Alpha Manager Ian Spreadbury agrees with Apel and Wells that corporates are attractively valued but sees this in investment-grade corporates in particular, as a result of spreads almost pricing in at recession-type levels. However, he warns that it is vital to be selective as a result of greater numbers of potential defaults.
“Corporate leverage has risen as companies have taken advantage of low yields to lever up to buy back shares or for mergers and acquisitions activity. This reinforces the need to remain selective in my view – even if there is a good chance that spreads could tighten from current levels. Striking the right balance between yield and liquidity will also remain extremely important in the coming year,” he said.
“Looking forward, given the low base level for yields, I do believe bond returns will be lower than we have been used to over the last five to 10 years. My base case for 2016 would be for mid-to-low single-digit returns from investment grade corporate bonds. However, this is still positive in real terms and I do feel that bonds will continue to play a key role in smoothing out volatility in investors’ portfolios and working well as equity diversifiers.”
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