The bond market is facing a perfect storm of rising inflation and rate hikes, according to European Wealth’s Nigel Marsh, who warns that many investors continue to pile into the asset class for its perceived safety despite the fact much of fixed income is now priced for perfection. 
Many market commentators have been predicting a very painful period in fixed income as they say yields have become detached from economic reality – warning that the asset class is heading towards a crash.
The concerns have revolved around valuations, with certain managers arguing that yields in the asset class – which have been falling for a number of decades now – are too low and offer little protection against equity market risk. They also warn that if inflation or interest rates were to rise, bond investors face significant losses.
Despite these concerns, however, core developed market bonds have continued to play the role they have become so renowned for: as shown by the fact yields on the likes of gilts, treasuries and bunds have been falling while equities have been volatile.
While credit spreads – the difference in yield between corporate bonds and government bonds – have widened of late, most managers within the IA Sterling Corporate Bond and IA Sterling High Yield Bond sectors have also managed to protect investors.
Performance of sectors and indices over 3 months
Source: FE Analytics
However, with the doom and gloom surrounding the world seemingly overblown but 10-year gilts now yielding below 1.4 per cent, Nigel Marsh – investment manager at European Wealth – says the bond market is dangerously overvalued.
He warns that even a slight improvement in the economic backdrop could cause bond funds to post hefty and uncharacteristic drawdowns.
“A perfect storm of rising inflation and interest rates is looming. Bond markets have not been pricing in a potential interest rate hike – the credibility of the central banks is now questioned after years of them threatening rate rises and not delivering,” Marsh said.
“Therefore, when interest rates do finally rise, bond yields will be hit hard. Interest rate risk must be mitigated, and investors should ask their advisers if they are factoring this in accordingly.”
There are a number of managers who have held this view for a long period of time, but their relative performance has been hurt as a result.
One of whom is Artemis Strategic Assets manager William Littlewood, who has effectively been shorting government bonds for the past five or so years.
According to FE data, for example, the fund is bottom quartile over three and five years in the IA Flexible Investment sector and is down against its FTSE All Share benchmark.
Performance of fund versus sector and index over 5yrs
Source: FE Analytics
However, the manager is positive his positioning – which means the fund is 95.8 per cent short government bonds – will pay off.
“One day the actions of central banks will not work,” Littlewood said.
“They will either overstimulate, causing inflation, or they will lose their credibility. Were this to happen I would expect the government bond market to collapse. Our shorts in government bonds have been detrimental to the fund – but one day they will protect it.”
That being said, certain bond market bears have changed their tune of late; suggesting that the recent volatility in corporate credit has opened up a buying opportunity. These include Chris Iggo, chief investment officer of fixed income at AXA IM.
“We think this is an opportunity to add exposure to credit. Spreads are wide, interest rates are set to remain low and returns from credit markets are set to be better than in 2015,” Iggo said last week.
However, Marsh says investors are unaware of the risks they are taking by buying bonds now – particularly in the corporate credit market.
“With bond yields at their current lows, the risk/reward ratio no longer makes sense and investors need to be very wary of matching their risk profile to the bonds they buy or they will find themselves unknowingly moving up the risk curve.”
“Currently many investors may be unaware of the risks of owning bonds, particularly corporate bonds.”
“Furthermore, the difference between yields on both long and short-term bonds is so insignificant that there is no point in extending your exposure for longer than is necessary and short-term bonds are the only sensible option. For example, you can currently buy 30-year German bonds and 2-year US bonds at the same yield levels.”
Given most areas of the bond market have significantly outperformed equities since the turn of this century thanks to a gradual loosening of monetary policy, when that starts to change, Marsh says investors will realise that fixed income isn’t the safe haven it once was.
Performance of indices since January 2000
Source: FE Analytics
“Risk versus reward simply doesn’t make sense at the moment and so the smart money is likely to depart from bonds. For those that hold bonds as a ‘safety option’, their best option now is cash,” Marsh said.
“Following years of quantitative easing, low interest rates and regulation to improve liquidity, bond yields have been heavily suppressed. When inflation increases following the long anticipated rise in interest rates, the bond market will suffer another blow.”
