Is the 35-year bond bull run coming to an end?
It has been a remarkable year for bonds. Corporate bonds returned more than 12 per cent in the first three quarters of 2016, more than double the FTSE All-Share index return.
Yields are at their lowest on record across the world, on the face of it leaving new investors with little to go for.
However, some fund managers believe gilt yields, which are hovering around 0.7 per cent for the UK 10-year tenor, could be squeezed further.
Many believe corporate bonds, particularly high-yield, still offer value because interest rate, inflation and default levels remain low. The US corporate bond market in particular offers extensive choice and wider credit spreads than the European market.
CENTRAL BANKS SHAPING THE MARKET
The market continues to be shaped by central banks. The US Federal Reserve has hesitated to raise US rates in the face of faltering growth, narrowing the options for investors seeking yield.
Meanwhile, geopolitical concerns have weighed on sentiment, sending investors scrambling to the safe haven of government bonds.
In late September the Bank of England implemented a new corporate bond buying programme to purchase up to £10 billion in bonds over 18 months.
The bank published a list of eligible bonds - essentially those that add real growth to the UK economy, excluding financials - with the intention of lowering borrowing costs for firms that contribute to UK plc.
Fund managers have been trying to ascertain the bank's commitment to the project from its appetite for recent issues.
'We are trying to gauge how much the BoE plans to spend on a monthly basis and whether it is going to be price-sensitive, because the more it buys, the bigger the impact on spreads,' says Nicolas Trindade, manager of the Axa Sterling Credit Short Duration Bond fund.
'If the bank buys bonds above the levels they are valued at, that is a strong indication that it may go to £10 billion, and that could tighten spreads by another 20-30 points.'
The conventional view, however, is that bond prices at current levels are disconnected from fundamental valuations and unsustainable.
David Oliphant, executive director of fixed income at Threadneedle, says: 'The market is entering bubble territory in areas such as core government bonds, so in these cases the cost of a party ticket has reached a ridiculous price. Quite when this bubble will burst is uncertain.'
Many managers have joined the flight to quality. 'We don't want to chase the rally, so we are de-risking into strength,' says Trindade. He has been boosting his fund's cash balance and shifting towards defensive sectors and lower-beta names.
'The rest of 2016 and 2017 will be busy,' he says. 'The Italian constitutional referendum on 4 December will create political uncertainty, in 2017 there are French, German and Dutch elections, and we still do not know whether Brexit will be soft or hard.'
Longer-term structural deflationary forces at play in today's market could also push UK and US bond prices yet higher. John Pattullo, co-manager of the Henderson Strategic Bond fund, points to ageing populations, a surplus of savers and a change in attitudes to debt following the financial crisis.
Demand for yield has been further exacerbated by Japan's pledge to anchor 10-year government bonds at zero, forcing the nation's pension funds to look overseas.
On the supply side, world trade has been shrinking for several years, and there is excess capacity across car manufacturing, steel production, cement mixing and shipping. Most businesses don't need capital, as their factories and plants are not working at full capacity.
HOW TO SELECT A BOND FUND
All this makes selecting a bond fund challenging. Our tables show the top-performing sterling corporate bond funds - the outperforming bond sector over the past year - and strategic bond funds, which have mostly lagged behind, despite enjoying greater flexibility to navigate challenging markets.
'The sterling corporate bond market has produced some impressive returns this year, confounding the prevailing wisdom at the time that the first US rate hike would herald the beginning of a return to "normal",' says Ben Edwards, manager of BlackRock's UK Corporate Bond and Sterling Strategic Bond funds.
The corporate bond market could have further to run, because the difference between credit spreads and interest rates is still around 140 basis points for the global investment-grade universe and 500 basis points for global high yield.
Defaults are likely to remain low. With the crude oil price around $50 a barrel, oil companies are no longer in jeopardy, firms have cut costs and interest on loans is manageable.
However, strategic funds can invest across various bond classes and geographies as well as altering their sensitivity to interest rates. Some have exposure to currency as an additional lever, while others such as M&G Optimal Income can invest in equities.
This flexible approach should win out, given that economic conditions affect different parts of the bond market in different ways. For example, government bonds and investment-grade companies tend to perform better in tougher conditions.
Bond assets also have different levels of sensitivity to interest rate changes, so managers can in theory take long- or short-duration positions in different regions, depending on their expectations for interest rate movements.
Many strategic bond funds made 'thematic mistakes earlier this year, such as being heavily invested in emerging markets or the energy sector,' says Fabrice Jaudi, at S&P Investment Advisory Services. In fact, some funds closed after taking a hit on the energy sector.
'Many active managers failed to get duration right. Their positions relative to the benchmark was short because they thought interest rates would rise and push inflation up, making companies pay more than they expected.
'But UK inflation is currently 0.6 per cent, and rates won't rise with zero inflation or growth,' says Nathan Sweeney at Architas, whose Multi-Manager Strategic Bond fund is 30 per cent in long-duration sovereigns, compared with a market average of around 20 per cent.
Arguably, of course, if a fund is producing an unusually high return, it may be taking too much risk. You need to look under the bonnet for collateralised debt obligations or assets linked to Chinese property, Eastern Europe or payday lenders.
Managers of funds of funds may be able to identify positions that correlate negatively with each other, which helps suppress volatility. For example, Bryn Jones, manager of Rathbone Strategic Bond, says this is the case with the NeubergerBerman Floating Rate fund and the M&G Global Macro fund.
Jones adheres to a well-diversified core asset allocation framework, with the aim of maintaining a low correlation to equities.
'We think the fund will trundle along nicely,' says Jones. 'It should do well in any environment, producing good second-quartile returns, but with lower volatility than its peers.'
FUND SPOTLIGHT: M&G OPTIMAL INCOME
Fund manager Richard Woolnough is wary of the asymmetric risk profile of gilts at current prices, and he prefers credit, particularly long-dated US credit.
'Our dollar investment-grade exposure now exceeds sterling investment grade, and the fund's high-yield exposure is mainly in dollar assets,' he says. 'Within financials, I favour US banks over UK or European names.'
He says the UK economy should pick up over the next few years, as retail spending and employment look firm, a weaker sterling favours exporters, and manufacturers are likely to increase production in the period before the UK exits the EU, which could last several years.
'In the US employment data suggests the economy remains on track, helped by low rates and a lower oil price,' Woolnough adds.
'Signs of inflation are beginning to appear, and a robust labour market will continue to support this. We believe the Fed will need to raise rates imminently to curb future inflation, as monetary policy can act with a lag of up to two years.'
The fund currently has a 5 per cent equity weighting. At a stock level, Woolnough again prefers the US: quality issuers such as Microsoft, Apple and Verizon.
He has a relatively large position in the asset-backed and mortgage-backed sectors, as he likes assets backed by cash flows as well as the floating-rate nature of much of the issuance.