Bond yields aren’t likely to rise as rapidly as markets are expecting and deflationary pressures could mean interest rates remain low, according to Aviva’s Chris Higham and Kames Capital’s Adrian Hull.
This comes following last year’s sharp rise in yields, which was caused by expectations of fiscal expansion in the UK and the US.
While, for instance, 10-year gilt yields are up 81.7 per cent over the last six months alone, neither of the fixed income professionals are convinced this trend will continue with the same vigour later in the year.
Performance of index over 6months
Source: FE Analytics
“I understand why fixed income has been an area of concern given that interest rates at zero and – although the UK isn’t always the perfect example because you have 350 years of history – this is the lowest interest rates have been at,” Higham (pictured), who manages the five crown-rated Aviva Investors High Yield Bond fund, said. 
“If you look around globally, in the UK they’re actually quite high. There are lots of countries with negative interest rates.
“The total returns from fixed income last year were better than we expected and, post Brexit, there was certainly a lot of reassessment among clients who had been nervous about fixed income, that interest rates could actually go lower.”
He added: “The main question is ‘when will interest rates go up’ but clearly they’ve only continued to go down.
“We share a lot of those client concerns but, equally, there are a lot of big drivers in terms of debt levels, demographics and our general lack of inflation and deflationary pressures. So we’re more in the camp of interest rates staying low.”
During the first half of 2016, bond yields plummeted to unprecedented level as investors scrambled for steady streams of income, given that ultra-loose monetary policy had kept interest rates at unusually low levels.
Not only this, a general sense of bearishness caused by geopolitical uncertainty also encouraged a mass bid for safety. Unusually, while gilt yields continued to fall, the FTSE 100 index also continued to rise as it was bolstered by the post-referendum fall in sterling.
However, this landscape changed dramatically during the second half of the year. The election of Donald Trump as US president, combined with UK chancellor Philip Hammond’s Autumn Statement, caused investors to pile out of bonds en masse as the likelihood for fiscal loosening increased.
Performance of indices in 2016
Source: FE Analytics
While many investors believe such policy will boost inflation and provide support for interest rate rises – which would eat into the value of any coupons paid out by bonds – Higham believes there are too many deflationary forces at work for this to happen aggressively.
“On the inflation side I think this year will be pretty difficult for Carney and the UK, largely because of transitory factors. In the short term, we believe there are some inflationary pressures,” the manager said.
“Over the medium to long term, there are still a lot of deflationary forces at work, technology being the main driver of that. In the US it’s mainly about the labour market, that continues to tighten. Unemployment rates are the lowest they’ve been since the crisis.
“There are lots of caveats to that as the participation rate is down and that encourages more people to enter the labour market. We will see but, certainly with a lot of the political rhetoric, you would expect that to put more upward pressure on the cost of labour, so you expect to see greater wage pressures.”
Higham is fairly equally-weighted in terms of asset allocation as, currently, he says it is difficult to find any area of the fixed income market that is cheap compared to historic valuations.
That said, he believes central banks are unlikely to hike rates as drastically as markets appear to be pricing in. In terms of credit, he says there don’t seem to be any pressures on company balance sheets that could lead to large corporate defaults.
“I think ultimately we continue to see a demand for income because of interest rates staying at these low levels,” he continued.
“We’re fairly balanced in terms of our asset allocation so we share a lot of those concerns but, equally, if policy makers are successful – and they have proven to be – then they’re likely to continue to move down.”
Adrian Hull, fixed income product specialist at Kames, says investors believe rates will rise because they’re focusing on the short end of the yield curve.
He also says fears have been exacerbated by media hype, and urges investors to look through any short-term market noise.
“We have this joke every now and then, ‘Kames says bond market is fairly priced’ isn’t really a good headline. ‘Kames thinks gilts will freefall’ is slightly more interesting,” he said.
“The perception from markets is that the direction for yields is higher, and there are lots of factors markets believe to be the case when it comes to pushing yields higher.
“I think we’re just a little more sceptical about that happening in a straight line, and how aggressive that is going to be.
Performance of indices over 5yrs
Source: FE Analytics
“There is complacency in that view. We think a quarter of a per cent in government bond markets will actually present quite good value as a buying opportunity.”
The fixed income product specialist adds that the financing of fiscal spending and tax cuts in the US – a factor that has sparked concern about the country’s debt levels - is an “unknown unknown” yet is strongly dictating fixed income market movements.
“While we may have a rough concept of what the overall ideas might be, we don’t really know how they are going to be implemented. That is certainly a potential dampener in terms of new supply to bond markets that makes investors a little more concerned,” Hull said.
“Again, my slight hunch is that some of these expectations will happen. But as long as it’s not the most left field of outcomes, I think the market it probably more sanguine than people perceive.”