Since the financial crisis, aggressive monetary easing measures have suppressed the premiums investors have demanded for holding fixed income assets. However, with major central banks moving toward monetary tightening, the compensation required for holding bonds is likely to increase. 
As we have seen over the last few weeks, developed market government bonds have come under significant pressure as investors have started to reprice the liquidity premium attached to central bank actions. After years of cash being pumped into the global financial system, the tide is turning and liquidity is being withdrawn. Central banks are tightening monetary policy in synchronisation.
The recent correction has helped to correctly price in higher premiums in some countries. In the US, for example, the five-year/five-year forward breakeven rate currently hovers around the 3.25 per cent level, which is above the Federal Reserve’s current long-term terminal rate expectation of around 3 per cent.
Potential for price pressures to intensify
What about inflation premiums? After years of subdued inflation, there is the potential for price pressures to increase across developed markets on the back of stronger global growth, higher oil prices, and tight labour markets in several developed countries.
Germany, in particular, stands out in this regard: with record-low unemployment and ongoing economic strength, there is a risk price pressures in the eurozone’s largest country could begin to rise – possibly amplified by the European Central Bank not acting quickly enough. So far, the price of Germany’s 30-year bonds is yet to reflect these risks and we have singled this out as one of the preferred developed market bonds to express a short duration bias or underweight position.
In other markets, inflation-linked bonds remain an attractive opportunity as protection against the risk of rising inflation pressures. In particular, the US continues to offer reasonable value.
Some credit markets are priced for perfection
Meanwhile, demand for credit remains fairly robust, as strong global growth and a low default environment is supportive for fundamentals. However, the credit premium is looking somewhat stretched, with spreads relative to government bonds at historic lows, especially if analysed on a risk-adjusted basis. Similarly, the differential between BBB-rated and B-rated bonds is at record lows – generally a sign the market is no longer differentiating between rating qualities and risk structures.
We believe some credit markets are almost priced for perfection. For example, the premium between BBB-rated prime auto asset-backed securities (ABS) and BBB rated-subprime auto ABS is almost non-existent, even though delinquencies in subprime auto are back to 2008 levels.
These conditions suggest it may be time for credit premiums to reprice higher. But what is going to be the trigger point – higher bond issuance, less central bank buying, or investor sentiment shifting? While the potential catalyst for wider spreads remains unclear, the volatility shown in credit markets recently is a good reminder investors are likely to require a higher credit premium at some point this year.
Quentin Fitzsimmons is portfolio manager of the T. Rowe Price Dynamic Global Bond fund. The views expressed above are his own and should not be taken as investment advice.