Several headwinds for credit markets are likely to emerge during the next six months, according to Fidelity managers Ian Spreadbury and Sajiv Vaid, despite strong performance continuing into 2017. 
FE Alpha Manager Spreadbury (pictured) says there are several structural and political issues likely to impact fixed income performance later in the year.
The manager says valuations remain “a bit stretched”, particularly in low-yielding government bond markets and the high yield space.
While there have been some signs of strengthening economic growth at the start of the year, Spreadbury says ageing populations are likely to signal slower GDP increases, while increasing global debt-to-GDP is also likely impact growth.
“On the political side with Brexit negotiations coming up and European elections so far going a bit more smoothly than expected, the Trump transition: all these factors could throw up volatility in the next few months,” he explained.
“On top of that, the tightening cycle in the US the start of tapering certainly in the UK and Europe and balance sheets in the US could all impact markets in the next few months.”
Vaid added: “There’s no doubt about it, the last three-four months the inflation theme has really caught on people’s imaginations and really questioned what people should do about fixed income markets.
“Headline inflation was always going to rise, irrespective of Trump victory given what was going on with commodities. But the reflation trade that the market has been debating has centred upon Trump’s policy.”
Vaid says credit markets have already begun to price in some of Donald Trump’s pro-growth, pro-inflation policies, with US yields rising by 60 basis points since the presidential election.
The manager says investors need to consider whether the recent rise in inflation has also been priced into markets.
"On that inflation front, I think there are two questions investors need to ask themselves: firstly, is it priced into markets? And, more importantly, do you think the increase in inflation is transitory or structural?” he said.
“Inflation expectations are already at five-year highs, so I would suggest that we have gone some way to pricing in some of this increase in inflation. Whether it is transitory or structural is a more fundamental question.
“We’re in the camp that it is very much transitory rather than structural. If it is something more than structural then government bond markets will respond by yields increasing, which will slow growth down and be deflationary.”
He added: “I would suggest that given what we’ve seen with the yields rising from November this euphoria about growth will be tested and could be signs that growth might not be as euphoric as people expect in Q2.”
Yet, Vaid says the Federal Reserve may react more aggressively to some of the new US president’s policies on tax cuts and fiscal spending by raising interest rates more frequently than currently anticipated this year.
The £3.9bn, three crown-rated Fidelity Moneybuilder Income, overseen by lead manager Spreadbury and co-manager Vaid, has returned 7.18 per cent over the past year, compared with an 8.34 per cent gain for the average IA Sterling Corporate Bond sector fund. It has a yield of 3.43 per cent.
Performance of fund over 1yr vs sector & benchmark
Source: FE Analytics
Spreadbury says he has been running lower duration in the fund – which aims to provide an attractive level of income – largely due to valuations, but is wary of bringing it down too much.
“When you think about duration in bond funds, you have to take into account some other factors. For example if you reduce duration you tend to reduce income,” he said.
“Also a lot of investors buy bond funds as equity diversifiers. As you take duration down the correlation with equities also rises.
“If think about bond fund having two key risks credit risk and interest rate risk. As you take interest rate risk down, then balance of risk in fund is more credit risk which is correlated to stocks. This is something to bear in mind if you bring duration down too much.”
He added: “If we’re right that we remain in low growth, low inflation environment I would expect correlation between high quality corporate bonds and equities to remain low. In other words: bonds should do a good job as equity diversifiers going forward.”
Spreadbury says investment grade debt continues to look attractive, although Vaid says the pair remain cautious on certain sectors and a preference for non-cyclical parts of the bond market such as regulated utilities and secured bonds.
Vaid said: “When look at high yield in rising default regime and if your view is that the interest rate cycle that the Fed might get aggressive, you are simply not being paid for single ‘B’, CCC area.
“On high yield valuations we are very cautious and is a stock picking exercise over the next 18 months in picking the right sectors.”
For his £1.8bn, two crown-rated Fidelity Strategic Bond fund, Spreadbury says he has also made several changes to the portfolio more recently.
The fund, which has a more global remit than Moneybuilder Income, has returned 12.20 per cent over the past three years compared with a 13.05 per cent for the average IA Sterling Strategic Bond sector fund. It has struggled over the past year, returning just 3.91 per cent compared with a 7.65 per cent return for the sector average.
Performance of fund vs sector over 1yr
Source: FE Analytics
“In the last year I have reduced risk generally in fund [and] taken duration down,” he said. “Having run overall duration [at] over 10 years last year brought it down to 4.6.
“I’ve also brought credit risk down reducing high yield exposure and that’s been done by crossover hedges and derivative hedges.Net of that current exposure to high yield is 10 per cent.
“The bulk of fund is high investment grade bonds, with 25 per cent in government bonds. Within that 6 per cent inflation linked. We’re also running 7-10 per cent in emerging markets.
“The sector is not positive in overall terms but have been some attractive opportunities.”
“We had strong exposure to Argentina. We recently took some profits [after holding for] 5-6 months but very good returns in local currency.”
In hard currencies, Spreadbury said the fund had exposure to some Indian corporates and Nigerian bonds, adding that overall the fund had 7 per cent invested in emerging markets.
He added that by reducing interest rate risk had skewed the fund towards dollar-denominated assets given the higher yields available.