Global government bonds returned 7.45 per cent in 2019 amid fresh monetary easing from policymakers. Investment grade bonds returned even more, with UK corporate credit returning 9.3 per cent last year. However, there are a number of headwinds this year that have the potential to decouple the almost perfect correlation between rates and credit this year. 
On one hand, the gilt market faces headwinds from fiscal expansion. Indeed, these risks could materialise as early as the Spring budget when the government’s fiscal plans are revealed, with this event alone having the potential to significantly increase the supply of gilts and push yields higher, especially in the long end of the curve. The government has made several pronouncements on big public spending projects and looks set to stick with major totems such as High-Speed Two or HS2.
On the other, the market is too complacent on Brexit being done, with the 31 December deadline – while some way off – certainly not pricing in much room for error on that front when we look at the gilt market today. The challenge of agreeing the future trading agreement in this time scale will mean that the probability of a “no deal”, while relatively low, is increasing.
In addition, there are global geopolitical tensions in the Middle East, as well as trade frictions between the US and China, that all have the potential to significantly disturb the market.
The key now will be central bank intervention, with the ongoing prospect of a rate cut in the UK having already sent gilts to their lowest level since April last year. The Bank of England’s Monetary Policy Committee (MPC) decided against a cut in January, but this could have been a delay rather than a reversal of the perceived direction of travel.
There was a bit too much priced in at the front end ahead of the MPC meeting, which has left markets disappointed. In the medium term, however, we are still of the view that the Bank of England might be compelled to act this year, should the economic picture not materially improve.
The Brexit uncertainty so far has contributed to a meaningful decline in UK economic activity that could see the need for a further policy response – be that from the Bank of England or some form of fiscal stimulus. Either way, the balance of risks for the UK are tilted to the downside.
Central bank intervention - or the lack of it – would therefore, as always, likely be the biggest contributing factor to the overall direction of the market. But while the Old Lady of Threadneedle Street didn’t cut rates on 30 January, there are structural forces, predominantly in supply, in the very near term that might keep pushing gilt yields higher.
Nonetheless, there will still be opportunities for investors if they are willing to be flexible.
Our base case is that fixed income will continue to be well supported this year, based on the aforementioned uncertainty. From a global point of view, UK credit, and investment-grade credit in particular, offers attractive opportunities. But issuer selection will be key.
Looking at specific sectors, generally we avoid UK retailers. The sector will see a double whammy from secular decline of brick and mortar as well as higher import prices after the full EU departure which would pressure margins materially.
There are attractive opportunities in the investment grade debt of UK companies relative to those of their foreign peers and/or euro- and dollar-denominated currencies. Stock selection will be of utmost importance in these turbulent times, where entire sectors and industries are likely to be negatively impacted by both secular trends as well as unknown relationship terms with the UK’s biggest trading partners historically.
There is selective value in the corporate debt of some financial services companies - and utilities in particular - at this juncture. In addition, we believe a healthy allocation to UK gilts will provide both portfolio diversification as well as insurance against the strenuous road forward to agreeing trade terms with the EU.
We are firmly of the belief that truly flexible mandates are best positioned to protect against the secular, political, and fiscal challenges that we see for the upcoming year. After all, even if it’s a benign year for fixed income, bond markets won’t travel in a straight line.
Credit markets and rates markets have had a strong January and there will be opportunities to redeploy cash at better levels in the upcoming months. Flexible strategies will benefit from these opportunities compared to those tied to proscriptive mandates.
Alexander Pelteshki is co-manager of the Kames Strategic Bond fund. The views expressed above are his own and should not be taken as investment advice.