There is little value in being invested in short duration government bonds as the rising interest rate environment is likely to contribute to a flatter yield curve, according to FE Alpha Manager Mike Scott. 
With central banks around the world beginning to raise interest rates, some investment professionals, have begun moving into short-duration assets for their fixed income exposure.
However, Scott (pictured), who co-manages the Schroder Strategic Bond fund, said investors are making a mistake by doing so as – despite recent rate hikes – longer-dated government bond yields have not moved much.
The US Federal Reserve has been among the most active of global central banks in raising rates, as the economy has continued to improve.
As the below chart shows, the five-year/five-year forward rate in the US – which signals the rate the market is projecting for the end of the interest rate hiking cycle – sits at around 2.3 per cent.
Performance of 5yr/5yr forward rate over 5yrs
Source: Federal Reserve Bank of St. Louis
“We think the terminal rate [the natural interest rate] is 2.75 per cent – that is where the base rates will end in this tightening cycle – there or thereabouts,” Scott said.
“So, it is much more of a flattening dynamic as the Fed raises rates because there is a limit to how far the back-end can sell off.”
He said there are a number of factors that should keep interest rates around the 2.75 per cent level over the long term.
“In my view trend growth is still relatively low and I think there are many reasons for that – an ageing population, service economy, demographics and so on and so forth,” he said.
“I think that does actually keep the long end quite anchored and is why I think it is much more of a flattening dynamic than a shift in yield curves.”
The only potential pitfall to this logic however is rampant inflation, which Scott said would push the longer end of the yield curve higher.
However, as a bond manager, Scott said he is more inclined to believe the world is in a disinflationary environment than an inflationary one.
Indeed, the same reasons he believes the long-end of the yield curve is anchored – such as demographics – are the same factors that should keep inflation subdued.
“Should I be proved wrong and longer-term inflation expectations start rising, then that would start to worry me about long-term bond yield valuations,” he said.
It is not just in the US where interest rates could begin to rise, with Scott noting that the European Central Bank and Bank of England may be about to begin interest rate hikes in the short-to-medium term.
“[As such] where we don’t see value across any global markets is at the short-end of government bond curves. I think that the front of the yield curve really is where you should avoid putting capital,” he said.
The manager has run the Schroder Strategic Bond fund alongside Paul Grainger, James Lindsay-Fynn and Thomas Sartain since 2016, during which time it has outperformed the IA Sterling Strategic Bond sector by 4.92 percentage points.
Performance of fund vs sector since manager start
Source: FE Analytics
However, for those wanting to avoid government bonds altogether but maintain short duration exposure, the high yield sector can offer some interesting opportunities.
As manager of the five FE Crown-rated Schroder High Yield Opportunities fund, Scott said the asset class offers investors a short-duration asset with limited exposure to interest rate sensitivity.
“It has very low sensitivity to interest rates because ultimately the companies in which you invest are relatively risky compared to other credit and therefore you demand quite a high credit risk premium on those bonds,” he said.
“That helps to offset the rise or fall in price of bond yields – so as government bond yields rise you are able to offset that by the large credit spread in these high yield bonds.”
Typically, the companies in the space are quite small, meaning they can be influenced by prevailing economic conditions.
If interest rates rise, it is traditionally because the economy is performing more strongly than expected and central banks are attempting to reduce this.
“When rates rise the economy is typically in quite a good place and therefore the companies are generally generating quite a lot of cash,” Scott said.
However, he warned that with spreads compressing over the last few years, it is much more of a stockpicker’s market than it has been previously.
“Now we are in a period where we have seen strong spread compression since the crisis and I would say that the ability of market to tighten any more is limited and as we look at the market today it is much more about a relative value opportunity,” he said.
And the opportunity may only last for another 12 months before investors should look elsewhere, as the end of the credit cycle will likely dampen economic growth.
“Where you tend to start seeing turns in the credit cycle is really when you start to see real rates move into positive territory,” he said.
“We are not there yet but I think by the end of this year you could see a flat yield curve and it possibly inverted and that usually signals a closing of the credit cycle. I can’t put a date on it but I would say it is a from 2019 onwards story.”
Scott’s £581m Schroder High Yield Opportunities fund has been the best performer in the IA Sterling High Yield sector since the manager took charge in 2012, returning 62.99 per cent – more than double the sector average.
Performance of fund vs sector since manager start
Source: FE Analytics
The fund, which has a yield of 6.23 per cent and a clean ongoing charges figure (OCF) of 0.72 per cent, is 40 per cent weighted to Europe where the manager said a number of positive fundamentals have boosted returns in recent years.
“Net supply has been negative which has been a very strong technical for the European market,” he said.
However, investors need to be vigilant against loosening covenants as a result, dissuading companies from moving assets around the group, paying out unnecessary dividends or indulging in mergers and acquisitions.