Last year, corporate bonds achieved stable returns and rocketed in popularity, following expectations of falling interest rates across most developed economies. As such, the asset class is entering 2025 at tighter spreads than markets have seen for some time, but also with more attractive yields as interest rates reached highs not seen in several years.

The performance of government bonds has been more volatile, according to industry commentators, and looks set to remain so. The election of Donald Trump as US president, combined with weaker economies across western Europe, means that while interest rate cuts are virtually inevitable, the timing and scale of them is relatively unknown.

Iain Buckle, head of UK fixed income at Aegon Asset Management, says: “We expect bond markets to remain volatile in 2025. The market currently expects a further 75 basis points of cuts from the US Federal Reserve over the next 12 months. The broader US economy still seems robust, however, and those 75 basis points of expected cuts could look optimistic if the labour market remains resilient.

“The political backdrop in the US will also drive volatility, given the market assumes a Trump presidency will lead to looser fiscal policy and higher inflation. We will learn more as he takes office, and the reality may not be what the market has implied. But it’s likely the style of his presidency will only add to the uncertainty and volatility in markets.”

David Knee, deputy CIO of fixed income at M&G Investments, agrees that Trump’s election will increase volatility across markets, as investors anticipate how his second administration pans out.

“The first Trump presidency showed what Trump said he would do and what he actually did was very different,” he reasons. “Bond markets will be watching for key policies such as tariffs, tax and immigration, which could potentially reignite inflation and limit the ability of the Fed to act, as well as add to already growing deficits.”

Over in Europe, Buckle says the outlook is “slightly more certain”. “Core European economies have been struggling for some time, negatively impacted by a weak Chinese consumer and growing competition from within China itself.

“We expect the European Central Bank (ECB) to continue to cut rates, with 125 basis points of cuts expected by the end of the year. It would take a further deterioration in the outlook for the market to price in further cuts, but that is certainly a possibility as we learn more about US tariffs early in 2025.”

To read more on the outlook for government bonds, credit, equities, emerging markets consolidation and Consumer Duty, visit the January edition of Portfolio Adviser Magazine

Now, another turn in truths may be occurring for the asset class, as the risk factors of corporate and government bonds begin to shift. According to Shaniel Ramjee (pictured), co-head of multi asset at Pictet Asset Management, bonds issued by corporates are currently “paradoxically safer”.

“A lot of corporates have managed their balance sheets very well. They’re not as leveraged as they have been in the past, and therefore the spreads that they trade out over and above governments are low, but they might stay low for longer periods of time because of the nature of a much more diversified opportunity set,” Ramjee said.

“These corporates aren’t as indebted as the governments, and by and large, we see less and less corporate bonds being issued versus government bonds being issued every week. The supply and demand of these two asset classes is different. So I think paradoxically, we’re in a period where government bonds are riskier than usual, and actually corporate bonds can be less risky than usual. And I think that’s an interesting difference today than we might have seen in years gone by.”

While the issuance of some corporate bonds has caused a bidding war among investors, government bonds from typically desired countries such as the US and UK are all too available for investors as they attempt to stimulate their economies.

Other countries with typically stable markets, like France, have been rocked by political uncertainty. French 10-year government bond yields currently sit above 3.4%, almost a percentage point above the 2.6% levels of last January. French yields now sit in line with the government bond yields in Greece.

See also: What does the gilt yield spike mean for UK bond prospects?

“Ultimately, these governments have borrowed a lot of money. They’re highly leveraged, and unfortunately, like we see in the UK, the propensity for these governments to want to come and borrow is very high. So the risk is that the credit worthiness of those countries are deteriorating, and no one wants to really think about reducing spending,” Ramjee said.

As of October 2024, the estimated UK government bond issuance for the 2024/25 fiscal year was £294bn following an expansion by Rachel Reeves during the Autumn Budget.

When markets opened on the day of the budget, the yield of a UK 10-year gilt sat at 4.27. As of market close on 6 January, the yield is 4.61. Year on year, yield has increased by 23%. In the last week, 30-year gilt yields hit their highest level in near three decades.

To Ramjee, this could be the beginning of a larger problem if the economy is not able to grow under the new fiscal policies.

“Particularly within the UK, we’re at a really high tax burden. But on top of that, what’s happening is that if you don’t grow the economy, the risk is that the government has to come back for more taxes in the coming years. And I think that’s the other element that markets are worried about, especially in UK gilts, is that the tax rises have not finished,” Ramjee said.

“That’s why it’s so important to have growth policies along with any other tax rises, because if you don’t have them, then the market will get more concerned that you’re not doing anything to actually to grow the economy. That’s what’s been weighing on the gilt markets to date.”

See also: Will bond yields stay higher for longer?

As the asset class shifts, Ramjee said its use in portfolio’s becomes less clear: government bonds in particular were traditionally seen not just as a diversifier against equities, but a way to manage levels of risk. Now, Ramjee said it can not be relied on as heavily for either of those reasons.

“Government bonds provided a good stabilizer in a portfolio. They provided income, but they also provided a diversifying effect. When equities went down, bonds went up, and that helped the overall balance of a portfolio.

“What we see now as those debt levels have risen, and as the risk in those government bonds has risen is that the correlations are no longer as good for multi-asset portfolios, so you can’t rely on them as much as you could before to give you that diversification. And I think that is worrying from a multi asset standpoint, that you have to rely on different types of assets to diversify you.”

The managing director tells Portfolio Adviser that, despite interest rates across the developed world already beginning to fall as inflation tempers, fixed income funds will remain popular among investors for their higher returns and attractive yields relative to cash.

According to the latest flow data from the Investment Association, fixed income funds attracted £1.8bn throughout the month of August, pulling overall sales of investment funds to £804m despite losses across equity, money markets, mixed asset and property.

“At the moment, our lowest-risk portfolio has a 15% allocation to cash and money-market instruments. Is this likely to be as high next year, or will this weighting come down and get partially moved into fixed interest? Given the yields on offer, I suspect it will be the latter,” Hughes says.

“This is a trend that we are already seeing now – albeit money market yields are still quite appealing in the short run – but I expect this to continue over the medium term, as this will start fading at the end of the year and early next year.

“I would absolutely expect money to flow out of money market funds and into the fixed interest market.”

See also: What does the gilt yield spike mean for UK bond prospects?

The question remains, according to the managing director, as to which types of fixed income propositions investors will favour. For instance, investors could move “one step up the ladder” and buy into short-dated corporate bonds, or they could “eke out a bit of extra return” by taking on more duration risk and moving into standard markets.

“I think it’ll probably be a bit of a mix of the two,” he reasons. “People will remember being burnt while holding bond funds only a couple of years ago, when they saw drawdowns of 15-20% in what is supposed to be a ‘safe’ asset class. So, I suspect people will be nervous about taking lots of duration risk at the moment, even if it might be the right thing to do.”

Portfolio rebalancing

Hughes has been positive on fixed income “all year”. In January 2024, when the firm was updating its portfolios with the team’s overarching views, it added “quite a bit” to the asset class on the expectation of interest rate cuts throughout the year. “We also thought the yields on cash were going to fall as well – which is two sides of the same coin,” he explains.

“So, we started moving out of cash and adding duration in January; we were doing this in a couple of places. We were adding to UK gilts and UK corporates. We thought that UK investment-grade corporates looked like the sweet spot to us – given the yield pick-up we were getting over cash and government bonds, as well as an incredibly low default rate.

“We were seeing an average 100 basis-point return over cash, maybe more at various points.”

See also: Three ways asset allocators are buying bond funds

This was during the first half of 2024, and Hughes admitted it “didn’t really work like that” given stickier-than-expected inflation data, and central banks “kicking rate cuts further down the road”.  

“Bonds actually underperformed cash during the first half of the year. But in the second half, we saw inflation data start to fall backwards quite sharply, with some employment data from around the world coming in slightly weaker. Then, we saw rate cuts come through in the eurozone, the UK and the US, which has clearly fed through to bond yields.

“This position started to work quite nicely for us in the second half [of the year].”

UK corporates and US treasuries

Hughes has a preference for UK investment-grade corporates because yields are higher than in the likes of the US or Europe. AJ Bell also reaps the benefit of them being sterling-denominated as opposed to receiving sterling-hedged yields.

“Compared to the likes of European investment-grade bonds, we are getting about a 1% yield pick-up on that,” he explains. “However, in our international bond bucket – our non-hedged bucket – we overrode using global government bonds as a core asset class and instead bought US Treasuries.

“The reason is that the global government bond index has some US bonds and some UK bonds, but it also has a lot of European and Japanese government bonds.

“Across both of these regions, the yields have been artificially supressed by government and central bank action. At the start of the year, you could get a 1% yield pick-up by owning dollar bonds rather than global government bonds.”

The managing director says there is the “added attraction” of the US dollar serving as a “safe haven hedge, if things get ugly out there”.

“Now, sterling has strengthened against the dollar, but it really matters. We were getting paid a higher yield, while benefitting from having a hedge in the portfolio if things got difficult. For us, it looked like an attractive trade and it has worked out exactly like that

“US treasuries have outperformed global government bonds this year.  I think this is a subtlety that quite a few people might have missed, that they benefit from the yield pickup and keep their edge without getting exposure to the likes of Japan and Europe.”

High-yield headwinds

One area of fixed income AJ Bell has been reducing its exposure to is high-yield fixed income. At the start of the year, the team had a 10-12% position in the asset class, but this has since been halved due to tight spreads.

See also: Square Mile: Are falling US interest rates the panacea for bond funds?

“We didn’t think we were being paid suitably for the risk we were taking,” Hughes says. “We have been wrong on that, because spreads have become even tighter. High yield has actually performed very well this year, largely on the back of strong equity markets, too. We had some exposure but not as much as we did have – that cost us a little bit.

“However, we’re very comfortable with the fact we took some of that risk out of the portfolios, because the risk-return trade-off did look weak at the end of August. On the day that the Japanese stockmarket suffered a big correction, high-yields spreads blew out by 1% in a day.

“This just shows what can happen when you’re trading at very, very tight spreads. As soon as any kind of shock or uncertainty rears its head, the risk of drawdown can be high.

“Therefore, we are perfectly happy parking that capital in investment-grade bonds – obviously while being paid a lower coupon, but having a much lower risk at the same time.”

The EdenTree Global Select Government Bond fund will target 80% exposure to government-focused green, social, sustainable, or impact bonds. David Katimbo-Mugwanya, head of fixed income, will manage the fund and will use EdenTree’s proprietary Oppressive Regime screen to remove countries that are identified as having an opressive regime. The screening process uses assessments from Freedom House, Transparency International, and the World Economic Forum to score countries on a range of criteria.

The fund will aim to offer regular income, payable quarterly. It joins the Edentree Responsible & Sustainable Short Dated, the Responsible & Sustainable Sterling Bond and the Global Impact Bond strategies in Edentree’s range of fixed income funds.

See also: Fidelity launches duo of sustainable bond ETFs

“In its latest assessment of development investment around the world, the United Nations (UN) estimates that $4.2trn per annum is required to close the development financing gap, up from $2.5trn before the Covid-19 pandemic. Urgent steps are needed to address global sustainable development funding requirements, and governments have a unique ability to mobilise capital at scale through vast debt issuance programmes, placing them in a prime position to fund projects that tackle these societal challenges,” Katimbo-Mugwanya said.

“Sovereign ESG-labelled debt issuance is continuing at an unprecedented pace, with government and or related issuance making up just over half of the outstanding global universe of use-of-proceeds green, social and sustainable debt. In a market environment that offers considerably higher bond yields compared to the last decade, the risk-return profile of government debt from an asset allocation perspective has markedly improved. As such, we believe this new fund is ideally placed to leverage these market dynamics in the best interests of clients seeking to credibly enhance sustainable fixed income offerings when allocating to government debt.”

See also: Alliance Witan makes manager change as portfolio transition completes

James Tomlinson, head of wholesale distribution, added: “The EdenTree Global Select Government Bond fund has been developed in close partnership with an existing client to meet a specific strategic requirement for a sustainable government bond solution.

“Fixed income is playing an increasingly important role for investors seeking to link financial goals with the desire to address pressing societal needs and environmental concerns. While equities have traditionally dominated the options available for responsible investors, fixed income now provides innovative sustainable investment products with varying risk profiles, degrees of impact and competitive rates of return. With this in mind, we are delighted to further enhance our fixed income offering, providing our clients with greater flexibility and increased choice when it comes to meeting their investment and sustainability goals.”

The circumstances of 2022 were extreme. Interest rates had been at unprecedented lows, and then rose incredibly fast. At sub-zero yields, bond markets had become vulnerable to a sophisticated version of pass the parcel, where instead of a present, the person left holding it would be left with a portfolio of underperforming debt.

To be clear, fixed income markets do not have the same vulnerabilities today. However, some concerns have started to emerge on valuations. There are question marks over whether government bond markets are pricing in too high a level of interest rate rises, and whether corporate bond spreads leave any margin for error.

See also: Small caps: Is it time for some UK cheer?

Looking at corporate bonds, Damir Bettini, fixed income portfolio manager at Capital Group, agreed that there are risks.

He said: “There is an ongoing vigorous debate in the market as to whether global corporate bonds are expensive or offer good value. Those that are making the case that the asset class is expensive points out that credit spreads are at multi-decade tight levels.”

He admits that current spread levels suggest a negligible chance of recession, adding: “If we get a reasonable-sized recession – something that is consumer-led, and impacts asset quality, there could be 100bps of spread widening.”

However, he said the greatest risks come in a stagflation scenario, where central banks need to raise rates because inflation takes off and there’s no growth. He believes this scenario looks unlikely and that’s why markets are generally taking a positive view. For him, the global economy appears resilient, with inflation falling and plenty of scope for central banks to cut rates even without a recession.

Bettini added: “Even if corporate bonds do look expensive at an aggregate level, it is a broad, deep asset class. We see a fair amount of dispersion across regions and across industries. The US is very expensive, while Europe has lots of interesting investment opportunities. The UK is currently sitting between US and Europe and we’re also finding good opportunities in Asia.”

Perhaps, most importantly, corporate bonds still offer an attractive yield. Dillon Lancaster, manager on the TwentyFour Dynamic Bond fund, said: “When yields are attractive and correlations are correct – ie a negative correlation between corporate and government bonds – fixed income markets usually behave very well. Our Dynamic Bond fund has a yield of 6.7%, and the average rating for our holdings is BBB+.” This combination of high yield and low risk is likely to keep investors interested in the near-term.

Government bonds

Government bonds are facing different pressures, but the biggest problems are appearing in the US market.

David Roberts, head of fixed income at Nedgroup Investments, said: “At the time of the recent US rate cut US 10-year Treasury bonds paid a yield of 3.65%. Thanks in part to stronger than forecast data, stronger perhaps than the Fed had anticipated, that yield actually increased to more than 4% by 6 October. Yields had already been rising for a couple of weeks prior to [Jerome] Powell cutting rates – markets priced too many cuts, were too worried about the jobs market and started to fret about post US election fiscal policy.”

Lancaster said post-election policy is a worry, with neither side appearing to care very much about whether the deficit keeps expanding.

See also: Investment trusts: Retail investor take up of private equity trusts remains low

He added: “The main thing for the market is not who is going to win, but the make-up of the Senate and House of Representatives. The market will breathe a sigh of relief if there is a split government. The US is the founding father of checks and balances in its system. If there are competing interests from Congress and the President, nothing gets done. The market wants gridlock because that might help bring the deficit under control.”

His view is that longer-dated US government bonds could be vulnerable to a sell-off if there is a Republican sweep. Trump’s tariffs could be inflationary and there would be worries over any interference with the independence of the Federal Reserve. In a split government, long-dated bond yields could fall, and under Harris, they would probably stay unchanged.

Mark Dowding, BlueBay CIO, RBC BlueBay Asset Management, is bearish on 30-year yields. He said: “Looser fiscal policy points to a need for term premia to increase on a structural basis, and we think fair value for the long end of the curve is likely to sit closer to 5%.” It is currently 4.4%.

Lancaster said there is an Armageddon scenario, where the US experiences a Liz Truss style meltdown in its bond market. It is worth noting that a significant chunk of US treasuries are bought by ‘unfriendly’ nations, such as China. However, he sees this extreme development as a remote possibility, and believes there is always likely to be a buyer for US treasuries.

Government bond markets elsewhere do not have the same political risks, nor do they have the same expectations on rate cuts built in, though an Armageddon scenario would sink all boats. Non-US governments cannot afford to take such a devil-may-care approach to their deficits. This is particularly notable in the UK, when government bond yields have proved sensitive to merest hint that Chancellor Reeves may change the debt calculations to support investment.

The overall picture is that bond markets are not cheap in aggregate, but there is considerable nuance beneath the surface, with different durations, regions and sectors offering different value. On core metrics such as income and diversification, fixed income still earns its place, but there are pitfalls, and the environment argues for selectivity.

See also: Are the negative flows from UK equity funds justified?

This article originally appeared in our sister publication, PA Adviser

The strong performance from bonds pulled overall sales of investment funds to £804m for the month, despite losses across equity, money markets, mixed asset and property. It marks the third month in a row that sales have stayed net positive.

Equity funds experienced the largest outflows for August, losing £408m. It marks the second month of outflows for the asset class, which dropped £50m in July after a June upswing of £1.2bn.

See also: Fairview’s Yearsley: China becomes ‘story of September’

Bonds, however, paint something of the opposite picture over the last three months, after moving largely in tandem with equity until June this year. August is the bond sector’s second month of inflows, after a £518m increase for July, yet it lost £1.2bn in the month of June. Government bonds were the largest draw for the asset class this month, with £837bn in inflows.

Miranda Seath, director of market insight at the Investment Association, said: “The Fed’s more aggressive interest rate cut of 50 basis points in September represents a significant milestone, as the Fed seeks to steer the US economy to a soft economic landing and markets responded positively. 

“We have moved past the peak of the rate cycle in the UK and the US and the outlook for equity markets is improving but investors remain cautious, continuing to opt for bonds over equities. Recent short-lived market volatility in the US at the end of July was partly fuelled by poorer than expected jobs growth. The path to a soft landing could be bumpy and this could bring new pockets of market volatility. And whilst UK investor confidence is improving investors are also waiting to see what the Autumn Budget holds. Post Budget we may see further adjustment to asset allocation.”

August did not show investor confidence in the home market as of yet, as UK All Companies experienced £629m in losses, the largest across all sectors. UK funds by region also dropped £829m. Just North America and global funds attracted investors overall for August, with regional inflows of £527m and £308m, respectively.

See also: ISS: Model portfolio sales quiet in first half of 2024

The conventional UK investor has typically opted to allocate their exposure to EMD into blended strategies, which invest in a combination of the three subcategories. By investing with an active EMD manager within the blended space, investors try to benefit from the expertise of investment managers who tactically move portfolio exposures across the different subcategories as market conditions evolve, optimising the risk and return characteristics of the portfolios.

Nevertheless, EMD funds have not historically been favoured by the conventional UK investor, who prefers to dedicate their fixed- income allocation to more traditional and core strategies, such as government bonds and investment grade corporate bonds. The combination of political risk, default risk, liquidity risk and in some cases also currency risk, makes EMD a volatile asset class, and therefore outside the consideration of the defensive characteristics typically required for fixed income allocations.

See also: BNP Paribas names head of emerging market debt

The asset class remains therefore a specialist sector, home to more sophisticated clients such as institutional investors and family offices. The demand for emerging markets has slowed during the past two years, with significant outflows in the retail market.

The asset managers have also reduced the number of launches of new funds in the sector for the UK retail market over the same period, with the number of EMD funds across the Investment Association sectors increasing by only two funds. It stands at a total of 121, as of the end of March 2024.

Read Eduardo Sánchez’s funds to watch by assets under management, three-year performance and newcomers in May’s Portfolio Adviser magazine

The JPMorgan Liquidity Funds – EUR Government CNAV fund is a short-term public debt constant net asset value (CNAV) money market fund.

The strategy will invest in short-term EUR denominated government bonds, treasury bills, and other money market instruments, as well as reverse repurchase agreements.

See also: What does the future hold for money markets?

Jim Fuell, head of global liquidity sales, international at JPMAM, said: “With interest rates in Europe now firmly in positive territory after a decade of negative levels, we’ve observed growing demand from investors for a money market fund with exposure to short-term government rather than bank-issued short-term debt.”

The strategy will be managed by managed by Joe McConnell and Ian Crossman, and will offer share classes for retail and institutional investors.

JP Morgan’s Fuell added that the fund might appeal to investors seeking an alternative to cash deposits for their medium-term or temporary cash investments, including seasonal operating cash or the liquidity components of investment portfolios.

There is a high degree of uncertainty given the economic backdrop. Even among economists there’s uncertainty around the degree and the timings of a recession, for example. Therefore, it’s difficult to pick a strategy or sector that will do well in the short term. I prefer asset classes that are at historical extremes in terms of valuations, which means they’re more likely to normalise in the medium term. UK and European equities are looking very attractive, given the general outlook on earnings growth – especially relative to US equity valuations.

Q: What asset classes should investors be thinking about beyond equities and bonds?

Alternatives have always been a consideration in our portfolios, especially when rates remain extremely low. However, traditional assets such as equities and bonds are in a good shape right now amid a normalised rate environment. Diversification benefits from alternatives should be considered alongside the opportunity cost of not holding traditional sources of diversification such as government bonds. Investors should assess the premium they can expect from balancing their allocation to different asset classes.

See also: Generation Next with Imogen Millington: A pathway to value

Q: How do you see sustainable and ESG-oriented investing evolving from here?

I believe investors will come to think of it less as a trade-off between the investment returns and doing the right thing, but rather something that is very much integrated into the investment process. With the guidelines becoming stricter around what label investors can use for sustainable or ESG-oriented products, I expect that what people think of today as sustainable or ESG-oriented products will be at the core of what most companies will integrate into their portfolios.

Q: What will be different about the investment sector a decade from now?

I think we will see an improved understanding around the nature of active and passive investing. Rather than favouring one or the other the industry will evolve to understand in what environment the respective strategies work well, and therefore choose the right strategy at the right time. It is going to be interesting because passives are offered at a much lower price point and active managers will have to prove they can add value to be considered.

Read the rest of this article in the April issue of Portfolio Adviser magazine

And investors would appear to have recognised the opportunity. According to fund tracker EPFR, a record $22.8bn (£18.2bn) has flowed into US corporate bond markets over the year to date – the strongest annual start in five years. In the UK, corporate bonds were the second best-selling retail sector in January (after money market funds).

That said, fixed income performance since the start of the year has been relatively weak, suggesting the outlook may be more nuanced, and there are a range of factors that could destabilise bond markets in the near term. First and foremost is shifting expectations on interest rates. At the start of the year, it became increasingly clear the expectations for rate cuts in 2024 were too high. Government bond yields had fallen too far, given the likely trajectory of inflation.

“This caused a huge amount of easing in financial conditions,” says James Ringer, a fixed income portfolio manager at Schroders.

“This is one of the better leading indicators of where growth will follow and the impact can be relatively swift. We came into 2024 revising down the probability of a hard landing significantly and started revising up the probability of no landing.” This re-adjustment of rate expectations has been a major driver of the weakness in bond markets since the start of the year.

US debt levels

While that adjustment is now complete, there are other factors that may exert a longer-term influence on fixed-income markets. The level of US debt, for example, is a risk factor. The US fiscal deficit in 2023 was $1.7trn, an increase of $320bn from the previous fiscal year. For the year to date, the Federal government has spent $828bn more than it has collected in taxes. On current rates, the government will be spending one-third of its income on debt interest by 2030.

On most measures, this looks unsustainable – yet neither presidential candidate appears inclined to tackle it. Donald Trump is pushing for tax cuts, while Joe Biden would like more spending. Historically, the US government has been able to rely on a range of buyers for its debt, but some of these natural buyers are evaporating. At the same time, the US Federal Reserve has withdrawn support for fixed-income markets through its quantitative tightening programme – now manifesting as strains in the reverse repo market.

Historically, as and when domestic interest went cold, the US could rely on international buyers to absorb its debt – but there have been changes here as well. The Japanese, for example, have been strong buyers of US debt but, as the Bank of Japan raises domestic interest rates, there are signs they are turning back to their local market. There are also risks around geopolitics – China has historically been a significant buyer of US debt, but deteriorating relations between the two sides makes this less likely.

The real question, of course, is not whether there are buyers for US debt so much as the price they are willing to pay. Phillip Swagel, director of the Congressional Budget Office, has suggested the mounting US fiscal burden is on an “unprecedented” trajectory, risking a crisis akin to the Liz Truss/Kwasi Kwarteng moment in the UK.

While there has been plenty of speculation, however, such a crisis would not appear imminent. Spending on largescale infrastructure and green energy projects will ease, and the US may end up issuing a smaller amount of net debt than last year.

Furthermore, if there are any signs of strain in the market, the Federal Reserve is likely to slow its quantitative tightening programme, which would slow the supply of US treasuries hitting the market. Money market funds are also likely to be a significant source of demand so this should remain a risk about which investors need to be vigilant, rather than a source of immediate problems.

Read the rest of this article in the April issue of Portfolio Adviser magazine

The bond market has been giving conflicting signals. On the one hand, the government bond market was pricing in significant rate cuts, which implied a markedly weakening economic outlook. On the other, corporate bond spreads over government bonds were tight, suggesting that the market did not see an imminent rise in defaults.

These disparate views from different parts of the bond market have now been largely resolved. The yield on the 10-year US treasury has risen from 3.9% at the start of the year to its current level of 4.2%. Expectations of interest rate cuts have been pushed out. This puts government bond markets more in line with corporate bond markets, where spreads continue to be low.

See also: Will M&A and buybacks breathe life into the UK stockmarket?

However, this poses a different question for fixed income investors. James Ringer, fixed income portfolio manager at Schroders, says the more pressing discussion for his team is whether markets have now overshot. The bond market is both cause and effect. As the US Federal Reserve started to talk about rate cuts in November last year, it pushed government bond yields lower. This created an effective stimulus in the market, which “greased the wheels of the economy,” says Ringer. “The market narrative has shifted quickly. The market has priced out the probability of a hard landing.”

A hard landing still looks unlikely. The January non-farm payrolls report showed ongoing momentum in the US labour market, and the latest GDP figures also showed broad strength across the US economy. Ringer says: “The non-farm payrolls report was huge and wage growth was buoyant as well. That set off a chain reaction, compounded by the CPI report. A number of data releases shifted people from one side of the boat to the other in very short order.”

However, he adds: “When that happens, there is typically an overshoot. We’re currently debating the extent of that overshoot.” They still see the rate of wage inflation falling to a level more consistent with central bank targets. They still see inflation falling, even though there is a blip. “The market may have gone too far in pricing out a no landing versus a soft landing, and has also gone too far in pricing out a hard landing.”

In portfolios

While that means that government bonds look better value, there are still some parts of the corporate bond market that look stretched. In particular, Ringer highlights US dollar-denominated investment grade bonds. “They are now approaching the lows in credit spreads seen when the central bank had just created a bond purchasing programme. We prefer European investment grade credit, where spreads are not at historically tight levels.”

Donald Phillips, co-manager on the Liontrust Strategic Bond fund, is underweight both investment grade and high yield. Investment grade exposure was reduced by 10% during January to 42% – their neutral position is 50%. They have a small underweight in high yield – 18% versus 20%. “The economy is slowing down and credit is priced for perfection,” he says.

See also: As governments roll back on green pledges, can the outlook for clean energy improve from here?

Nevertheless, he says the outlook for credit is still benign and they remain poised to add to their credit holdings if there are periods of volatility. He says high yield is higher quality than it has been historically, and the overall yield is still attractive. He is focused on the BB or B area of the market and on sectors where there appears to be some mispricing. He would include areas such as real estate in this. While there are some obvious problems with the office market, “the baby has been thrown out with the bath water, particularly in Europe”, he says.

Nevertheless, he believes government bonds now look attractively valued, with a relatively high yield. The fund remains longer duration, at seven years, and he believes interest rate cuts are still coming down the track. He admits they were a bit early, but, “we are paid to wait”.

Different regions

There is also a question over whether there is a greater gap opening up between individual regions. While the US continues to record strong economic growth, the UK and Eurozone are flirting with recession. This is likely to bring inflation down harder. Yet their government bond markets continue to move in lockstep.

The assumption is that the Europe and UK markets will not be able to cut ahead of the Federal Reserve. However, Ringer believes the ECB and Bank of England may be more independent than markets believe: “Where central banks aren’t as independent is where the economic is highly sensitive to the currency – more a feature of the developing world. I would like think the Bank of England and ECB have a degree of independence from the Fed.”

See also: Diverging performance: What is driving emerging market returns in 2024?

He believes that central banks will follow their own mandates and whichever central bank feels most confident on the inflation trajectory will cut rates first. This suggests that the overshoot may be more acute in the UK and Eurozone. Dickie Hodges, head of unconstrained fixed income at Nomura Asset Management, for example, has been reducing duration, with the notable exceptions of intermediate German bonds and long-dated UK bonds.

Ultimately, a soft landing remains the most likely scenario, given the data. However, there are risks on either side, and the market may now be under-pricing the risk of a negative outcome for economic growth, particularly in the UK and Europe. Corporate bonds and government bonds appear to be moving to a more harmonised view on the economic outlook over the next few months.

With bond yields finally rising and interest rates also increasing it’s easy to understand the appeal, but year-to-date data from FE Fundinfo shows while the numbers are nowhere near as bad as last year, the UT Fixed Interest sector is still down by 0.92%.

However, the latest sales data from the Investment Association (IA) shows this isn’t detracting investors, with the IA UK Gilts, Corporate Bond, Government Bond and Sterling Corporate Bond sectors being the top four sellers in net retail terms in September.

See also: High-yield bonds: Buy or buyer beware?

Indeed, while equity funds suffered outflows of some £1.3bn, fixed income as a whole only suffered £73m of redemptions in September, which was dragged down by significant selling of the Sterling Strategic Bond sector.

So, heading into 2024 after a tough two years, can fixed-income funds once again provide their traditional source of diversification?

In this edition of head to head, Yoram Lustig, head of multi-asset solutions, EMEA, at T Rowe Price, looks at the themes that will drive markets this year, while Phil Milburn, co-head of the Liontrust global fixed income team, argues the case for patience when holding bonds.

To read more, visit the December edition of Portfolio Adviser Magazine