The lessening impact of loose central bank policy, the upside potential for inflation and the risk that the Federal Reserve could begin tightening mean that bond investors should limit risk as much as possible in their portfolios, according to Chris Iggo (pictured). 
The chief investment officer for fixed income at AXA Investment Managers says policy tools used in the near-future are likely to lead to steeper yield curves.
Not only this, he points out that the abundance of political risk across global markets needs to be considered carefully, particularly the US election and what will happen in the UK after Article 50 is triggered.
“Credit spreads are stable, but markets face significant risks in the coming months, mostly on the political side,” he said. “The US election is key and we will re-visit our asset allocation before that event.”
“The overall tone is to limit risk as we are wary of ‘taper tantrum’ type moves in rates and event-related risk in spread products.”
Fixed income investors have endured a turbulent time over recent months. Last year’s initial fears that the Fed was due to hike rates imminently were soon forgotten, as ultra-low interest rates caused investors to flock to bonds for both safety and income.
Since the start of the year, 10-year gilt yields have fallen by 65.05 per cent to lows of 0.68 per cent while 30-year gilt yields are down 47.43 per cent at 1.39 per cent – this is despite the fact that many investors deem fixed income assets to be significantly overvalued.
Performance of indices in 2016
Source: FE Analytics
Not only are valuations high, many fixed income investors have recently expressed concerns surrounding a further rate hike from the Federal Reserve, which could be detrimental to those who currently hold bonds in their portfolios.
At the same time, there are concerns that ultra-loose monetary policy deployed by the Bank of England (BoE), the European Central Bank (ECB) and the Bank of Japan (BoJ) is losing its effectiveness over time and will eventually reach its limits, causing rates to rise again.
“For some time there have been concerns that monetary policy is reaching its limits and that some aspects of the policy mix have negative implications for financial stability and economic behaviour,” Iggo said.
“For example, negative interest rates and very flat yield curves are not helpful for the economics of banking and insurance sectors. Moreover there is some evidence that household savings behaviour is reacting to lower rates in an inverse way.”
“In addition, many economists are calling for fiscal policy to play a greater role in boosting growth and inflation in developed economies. Low long-term bond yields provide governments with the opportunity to increase borrowing in order to invest in long-term strategies to boost productivity – infrastructure, technology and education.”
“The multiplier effects from fiscal policy are understood to be greater than is the case with monetary policy, thus allowing growth and inflation targets to be met with more certainty.”
That said, the CIO doesn’t expect significant policy change over the shorter term, given that the ECB and the BoJ have acknowledged constraints such as declining returns to policy.
It may not happen straight away but Iggo says monetary policy is a dominant theme in bond markets, despite the fact he believes that the biggest impact of global monetary stimulus is now behind us.
“Further declines in yield levels will be hard to sustain as the ECB struggles with increasing its bond purchases, the BoJ shifts towards a steeper yield curve target and the US Federal Reserve continues to debate whether it needs to raise interest rates or not. As such, we do not expect significant further total return gains from interest rate moves,” he added.
Jan Dehn, head of research at Ashmore, says that QE economies are poised on a knife-edge between recession and inflation and points out that, ironically, markets are more focused on the impact that monetary easing will have on emerging markets than on the QE economies themselves.
“Objectively, EM economies are rapidly becoming the only ‘normal’ countries left on the planet, in the sense that they have regular business cycles, use conventional policies, have reasonable debt burdens, sensible asset price valuations and so forth,” he said.
“Moreover, EM countries have recently demonstrated considerable resilience. They have just come through a hurricane of headwinds – the start of the Fed hike cycle, the USD rally, the ‘taper tantrum’ and falling commodity prices – without a major pickup in defaults.”
As such, he says that fixed income investors could fare well from buying into emerging market bonds, given that emerging market asset prices have become less correlated with Fed fears and that developed market bonds’ sensitivity to rate hikes has been growing over the course of the year.
Not only this, he points out that emerging market bonds offer far more attractive yields than most fixed income assets within developed markets.
“Remember that EM bonds also pay 6.26 per cent yield for the same duration that in the US pays just 1.26 per cent and which in Germany pays -0.51 per cent,” Dehn continued.
“Despite its many merits EM bonds remain far from many investors’ radar screens. Global asset allocators have shunned non-QE markets for years, particularly EM as they chased risk in developed economies.”
“Flows have barely begun to return. Investors are scared about return prospects in developed economies. Since they still think of EM investments as risk-plays they are reluctant to allocate. Emotions do matter, but today EM is actually the safer play.”
Performance of sectors in 2016
Source: FE Analytics
Iggo agrees and says that emerging market debt looks particularly attractive at the moment. However, he also says that given that monetary policy in the UK and Europe is more focused on corporate bond purchases, there could be modest scope for tighter investment grade spreads.
“High yield continues to benefit from the search for yield and the fact that central bank eligible assets in investment grade markets are becoming very expensive. Defaults remain modest and net refinancing is manageable,” he said.
“In our view, emerging markets are a strong bet at the moment as a result of fundamental improvements in key economies and relatively attractive valuations.”