Fixed income markets have certainly been a topic of debate throughout 2016.
Concerns surrounding the oil price, China’s economy and a global growth slowdown at the start of the year led to a flight to safety, with the FTSE Global Government Bond All Maturities index significantly outperforming global equity markets over the initial six weeks of 2016.
Performance of indices over 6 weeks since 2016
Source: FE Analytics
However, as the US Federal Reserve became dovish on rate rises and commodity prices began creeping upwards, there was a dramatic shift in sentiment and investors began piling back into equities once more.
Unusually though, fixed income markets also continued to perform strongly, pushing bond yields to all-time lows. One of many reasons for this unorthodox market behaviour could be ultra-loose monetary policy exacerbating the hunt for income as investors buy into mega-cap, dividend-paying ‘stalwart’ stocks as well as coupon-paying bonds.
This market behaviour has begun to unwind somewhat in recent weeks, as shown in sharply rising bond yields. For instance, 10-year gilt yields have risen by 85.32 per cent since the start of October and, at the time of writing, are at 1.4 per cent.
Many professionals attribute this to increased inflation expectations but, as events over the course of this year have shown, it is virtually impossible to predict how macroeconomic and geopolitical events will unfold.
David Jane (pictured), manager of Miton’s multi-asset fund range, says the surprise election of Donald Trump as president-elect has already stimulated some existing trends while creating new ones. 
“Already markets were adapting to the end of the QE era, at least in the US, with the anticipation of further rate rises leading to long-term interest rates rising,” he said.
“We believe that a multi-decade bull market in bonds has come to an end, but we don’t expect a huge rise in yields in the short term, as continued intervention by central banks should prevent a massive sell-off. In particular, the Japanese central bank’s cap on 10-year yields at zero percent will make yields elsewhere look highly compelling if they rise aggressively from here.”
That said, Jane remains cautious on fixed income and has reduced his duration in the asset class given a potential rate hike over the medium term.
Fixed income investors are also wary of inflation throughout 2017. One of the biggest drivers of inflation expectations over recent weeks has been Trump’s plans to increase fiscal spending and introduce tax cuts. As Jupiter’s Ariel Bezalel points out though, there are numerous other potential drivers at play globally that have led markets to expect a rise in inflation.
“While the world remains hampered by enduring economic imbalances, the evidence suggests that inflation in the developed economies is indeed starting to pick up,” he said.
“Market indicators, such as breakeven inflation rates, are rising in the UK, US and Germany, putting upward pressure on government bond yields.
“In China, economic growth is ticking along nicely, a reflationary force that is reflected in resilient commodity prices, brighter US service sector data and wages, and in Europe, where the reflationary policies of the ECB are starting to bear fruit.
“The outcome of the US presidential election has been taken by the market as a further inflationary signal. Donald Trump has been particularly vocal on the need to boost fiscal spending, a measure he said he would fund via debt issuance. A meaningful debt-funded infrastructure programme could help to stimulate the economy and be quite inflationary.”
While this could indeed be positive for fixed income assets in the US, it has sparked a general debate regarding emerging market debt, given the strengthening dollar could have negative ramifications for the market area.
However, some industry experts believe that emerging market bonds could present attractive investment opportunities over the medium term.
Baring’s Ricardo Adrogué and Brigitte Posch say that improving fundamentals within emerging markets – such as a gradual pick-up in growth and an increasingly stable macroeconomic environment – will stand emerging market debt in good stead.
“Historically, EM corporate debt has shown low sensitivity to US rates, and the asset class also tends to have lower duration,” they pointed out.
Performance of indices since start of data
Source: FE Analytics
“Despite the fact that the US may be on track to increase rates, global developed market yields remain low relative to recent years.
“In our view, EM corporates currently offer attractive yields with less duration risk than many of their developed market peers. Within the EM corporate space, we prefer shorter-duration strategies that we believe will offer superior carry and roll-down per unit of duration and volatility risk.”
Not everybody shares this view, however. Ben Willis, head of research at Whitechurch securities, is far less positive on the asset class’s prospects as we head into 2017.
He warned: “The increased risk of higher inflation means that the consensus view remains in place for a US interest rate hike in December.
“Potential for higher inflation and interest rate increases lead to a stronger dollar and all of this is bad news for emerging market debt and currencies. Capital has been sucked from these areas due to higher bond yields in the US proving more attractive.”
Looking ahead to the new year, Neuberger Berman’s Jon Jonsson argues that US Treasury yields have already risen steeply but may have further to run as Trump’s policies become a reality. As such, he believes the market is underestimating potential action from the Fed in 2017 and beyond.
“Against this uncertain backdrop, we anticipate periods of heightened volatility for world bond markets throughout 2017. In terms of sectors, in the US we recently took profits in our US high yield holdings and moved to a neutral position,” he said.
“Elsewhere in the US we like financials, consumer credit and non-agency mortgages, as consumer balance sheets and house prices continue to recover. Our largest allocation is in non-agency RMBS. We have also been overweight US TIPS [Treasury Inflation-Protected Securities] since before the US election and look set to maintain this position in 2017.”
The US election in November isn’t the only geopolitical topic to be driving fixed income rhetoric at the moment, though.
Lewis Aubrey-Johnson, head of fixed income products at Invesco Perpetual, says politics is likely to remain one of the key risks facing financial markets over the coming year, given the recent Italian referendum and the impending elections across the rest of Europe.
“Over the course of 2017, there will be French and German presidential elections and a general election in the Netherlands. These elections have the potential to significantly raise levels of volatility,” he warned.
“Further, they will all take place against the backdrop of Brexit and the start of Donald Trump’s tenure as President of the United States in January 2017.
“Despite our cautious outlook, we think there are still some areas of the market that are relatively attractive. Inflation-linked bonds offer some opportunities for certain portfolios we manage, with inflation risks that are under-priced, in our view.”
Jim Leaviss, head of fixed interest at M&G, says that - despite this rise in populist parties and the trend towards growing dissatisfaction with globalisation - it would be extremely difficult for advanced economies to reverse this now.
“Those that turn inward may be temporarily successful in boosting growth through growing private and public debt levels, but ultimately risk deep recession as inflation and unemployment begins to rise,” he warned.
“An increase in borrowing today by consumers and governments is merely stealing growth from the future. For bond markets, this could lead to a renewed focus on the creditworthiness of government bonds, the traditional ‘risk-free’ asset, resulting in higher yields in the not-too-distant future.”
Charles McKenzie, CIO for fixed income at Fidelity, says that risks for government bonds are asymmetric, economic and credit cycles are well into mature stages and weak market liquidity could amplify any market downturn.
However, he says holding nothing in fixed income isn’t a solution either, given that investors are in desperate need for yield.
“Typically, the late stages of the economic and credit cycles are an opportune time to extend portfolio duration and reduce credit risk. Instead, the opposite is a mainstay position of many investors,” he said.
“The low yield environment has turned traditional asset allocation on its head as investors are betting on a cycle much longer than normal. Nonetheless, we believe there are better solutions available. To address the challenge of low government yields, shortening duration can be beneficial, but only if rates rise beyond what is priced and your market timing is perfect.
“Overall, it’s hard to see a repeat of the returns we have become accustomed to in fixed income so investors will need to make their bond assets work harder in 2017. Avoiding the herd and crowded areas of the market, embracing wider diversification and being nimble with allocation and hedging should be important parts of any strategy.”