There is little doubt that a bond market correction of some sort will eventually arise but investors could be left waiting for some time, according to several fixed income fund managers.
As such, some fund managers are turning to currencies and as far afield as Australia and Israel for their bond exposure to make money in a rising interest rate environment.
Central banks have tightened monetary policy and are raising rates as global growth has become more entrenched, but narrow credit spreads could make positive gains difficult to come by this year.
This had a negative effect on bonds in 2017, with the Bloomberg Barclays Global Aggregates index – which measures both government and some corporate bonds – down by 1.9 per cent last year.
Performance of index in 2017
Source: FE Analytics
Jon Jonsson, manager of the Neuberger Berman Global Bond Absolute Return fund, said: “In respect to central bank action, we do believe reducing balance sheet holdings – quantitative tightening – should add to volatility in fixed income markets, just as adding to central bank balance sheets – quantitative easing – had previously reduced volatility.
“In this environment, we are reducing corporate credit risk in our portfolio as we do not see reasons for further spread tightening. At the same time, we have increased risk in currency and rates markets as we see significant dislocations and attractive investment opportunities.”
Quentin Fitzsimmons, portfolio manager of the T. Rowe Price Dynamic Global Bond fund, said the results of central bank monetary tightening remain “relatively unknown for bond markets”.
“A synchronised tightening move among major central banks could give developed market government bonds a volatile ride over the course of 2018,” he said.
He added that navigating this uncertain environment will require a smart approach, with specific positioning on the yield curve likely to take centre stage within portfolio construction.
“[For example] US long-dated bonds should remain well anchored, despite pressure increasing on the short-end of the curve,” Fitzsimmons explained.
“However, the opposite may be true for Japan, where there is speculation the Bank of Japan may reduce its buying of longer-maturity bonds, which could result in a steeper curve.”
In the UK, technical factors such as demand from domestic investors will also matter over the next year.
While the short and middle of the UK curve look vulnerable in the current environment, he noted, potential support exists from technical factors for 50-year gilts as possible demand for this part of the curve from UK pension and insurance companies needing to meet future liabilities could keep yields low.
As well as yield curve positioning, he said another way of navigating the current environment is to identify countries that are potentially less sensitive to rising rates.
“Australia stands out in this regard. Although its domestic bond market is likely to react to a sell-off in US Treasuries, it should quickly revert to being driven by domestic fundamentals once the market settles. Israel also offers a potential refuge from interest rate volatility,” he said.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
Currently, the fund has an 18.4 per cent weighting to US Treasury inflation-protected securities (TIPS) but 7.9 per cent in Israeli debt.
However, central bank policy is not the only issue facing bond managers, with the reflationary, pro-growth elements of US president Donald Trump’s agenda still yet to come through. 
“When will a long-forecasted increase in government bond yields materialise and what is the impact of a wildcard such as North Korea?” asked Neuberger Berman’s Jonsson.
“As unsettling as it may be, we do not expect complete clarity on these questions in the near term, and we do think there may be some unexpected answers – including that the global economic cycle may nevertheless continue to power through.”
Andrew Jackson, head of fixed income at Hermes Investment Management, noted that a further challenge could be the return of volatility, which has largely been absent in 2017.
“It would be hard to overstate the lack of volatility within credit markets in 2017 against a backdrop of elevated geopolitical and financial risk,” Jackson (pictured) said.
With low volatility, liquid credit markets such as government and investment grade corporate bonds have tightened and compressed meaning investors have sought illiquidity and any other ‘risk premia’. As such, Jackson said that several markets feel like coiled springs.
However, perma-bears have been burnt so often that even they are tending to a consensus long position.
“For us at Hermes this means that our 2018 in credit markets will be broadly characterised by less beta more alpha, seeking returns through security and borrower selection rather than through leverage and casting our nets even more widely in order to capture as many opportunities to analyse as possible,” he said.
“There is little doubt that a correction of some sort will eventually arise but given current positioning, far from extreme interest coverage ratios and a potentially more predictable year for growth in major economies, we may be waiting for some time.”