Heightened political risk, increased debt levels and low global growth are likely to remain part of the backdrop for some time to come, meaning that bond yields could well remain low for a long time yet, according to Fidelity’s Ian Spreadbury (pictured). 
That said, the FE Alpha Manager, who heads up the £1.8bn Fidelity Strategic Bond fund, has become more cautious in his portfolios following increased volatility in fixed income markets.
For instance, he reduced the duration in the Fidelity Strategic Bond fund from seven and-a-half years to five years through September via a combination of US dollar, sterling and euro duration exposures.
“We believe it is only a matter of time before the fundamentals re-assert themselves,” Spreadbury warned.
“High debt, elevated political risk, low nominal growth and low inflation will continue to characterise the fundamental backdrop in our view. This will warrant a protracted normalisation process and low yield regime for the foreseeable future.”
Traditionally seen as a ‘safe’ asset class, fixed income markets have become increasingly volatile recently as more and more investors turned to bonds for stable income streams post the financial crisis.
This has led to valuations rising, yields falling to historical lows and, in turn, an increase in correlation between bonds and equities.
However, as ultra-loose monetary policy has led to a global hunt for income, bonds have continued to increase in popularity, with 10-year and 30-year gilt yields falling by 48.82 and 36.54 per cent respectively since the start of the year.
Performance of indices in 2016
Source: FE Analytics
Over the last few days, volatility in the bond market has increased, with 10-year gilt yields sharply rising to levels last seen the day after the EU referendum.
Laith Khalaf, senior analyst at Hargreaves Lansdown, says the sharp uptick in yields combined with the recent fall in sterling is probably due to overseas investors selling out of UK government bonds.
“Of course bond yields are still exceptionally low, but anyone holding government bonds has seen their capital value fall since the market peaked in August, and by quite some margin for longer dated bonds,” he said.
“Undoubtedly the bond market has gone from strength to strength in recent years, but this sell-off hints at the damage that could be done to bond portfolios if interest rates were to rise to more normal levels, admittedly a distant prospect, but one which such low yields don’t offer much compensation for the risk involved.”
A recent report from Pantheon Macroeconomics says that the rise in gilt yields is likely to continue over the medium term, despite economic weakness.
Part of its reasoning is that the recent rise in gilt yields reflects markets increasing their expectations for inflation rather than because they’re positive on medium-term growth prospects – this is shown through the fact that inflation-linked government bond yields have continued to fall over the last month.
It also notes that the bond market’s inflation expectations still seem too low, and adds that gilt yields are likely to follow rising US treasury yields next year.
It said: “Despite Brexit and the divergent outlook for monetary policy in the US and the UK, daily changes in gilt yields have remained closely correlated with US treasury yields. If, as we expect, 10-year treasury yields rise to 2.75 per cent by the end of next year, from 1.75 per cent currently, gilt yields will get caught in the crossfire.
“All told, we still think that gilt yields will trend up over the next couple of years, despite weakness in the economy. We expect 10-year yields to rise to around 2 per cent by the end of 2017 and to 2.8 per cent by the end of 2018.”
Spreadbury believes that investor fears – which have initially been caused by weak sterling, QE tapering talk and doubts surrounding central bank control - and are unlikely to ease any time soon, given that there is an impending US election, the UK autumn statement and the Italian constitutional referendum on the near-horizon.
He also remains sceptical that the Bank of Japan will meet its inflation target despite its continuation of loose policy, given it has missed its target for the last 20 years.
“However, yield curve targeting effectively puts a cap on yields and could well pave the way for more radical policy steps in the future (such as helicopter money),” the manager reasoned.
“There is no doubt in our mind that central banks can create inflation if they are aggressive enough, but they are well aware that it can be incredibly difficult to control when it gets going. An increased focus on UK inflation is inevitable given the fall in the currency, but we continue to think the inflationary impacts will be transitory.
“Talk of a shift in the UK's focus from monetary policy to more expansionary fiscal policy has intensified of late, alongside speculation about potential 'tapering' from the ECB. We think it is extremely unlikely the authorities will take stimulus away and steepen yield curves at this stage.
“It is simply not in the central banks' interests to create disorder in the fixed income markets – especially given the other headwinds in play.”
When it comes to positioning for continued low growth, low inflation and therefore low yields, Spreadbury says that reducing duration through a mix of euro, sterling and US dollar exposures makes sense from a risk-reward perspective.
By locking in gains from the recent fixed income rally, he explains he is increasing his protection against central banks implementing any unusual or unpredicted policies.
Performance of sectors in 2016
Source: FE Analytics
He also trimmed his sterling duration further last week and says that, with gilts significantly underperforming treasuries, his preference for US dollar duration has proven to be a tailwind to the fund’s performance.
“We believe the benefits that duration provides still outweigh the potential for capital loss from rising yields, but await catalysts for putting a bit more interest rate risk back on the table,” he continued.
“More broadly, we retain a preference for investment grade credit over high yield, as we remain cautious on the outlook for growth and the possibility of a deterioration in corporate credit quality.
“UK inflation-linked bonds have been on a very good run, but have been extremely volatile (last week a case in point) and continue to offer little incentive in terms of real yields. The strong performance of emerging market debt has continued and there is possibly further to go on that front – but not without a bit of volatility.”
Over the last decade, Fidelity Strategic Bond has returned 85.85 per cent compared to its sector average’s return of 55.38 per cent and its BofA ML Sterling Large Cap benchmark’s return of 82.47 per cent.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
It has done so with a top-decile annualised volatility, Sharpe ratio (which measures risk-adjusted returns) and downside risk (which predicts a fund’s likelihood to fall during negative market conditions). It also has a top-quartile Sharpe ratio (which measures the most potential money lost if bought and sold at the worst times) over the same time frame.
Fidelity Strategic Bond has a clean ongoing charges figure of 0.68 per cent and yields 2.37 per cent.