Why the boom is over for bonds in 2017
Once the staid, predictable part of an investors' portfolio, fixed income has now suddenly become a little more exciting; but not necessarily in a good way.
After a near 30-year bull market in bonds, the tide appears to be turning as monetary policy and inflation change direction and in the US a Trumponomics fiscal bonanza looms.
The consensus is that the era of record low bond yields may be drawing to a close. In the closing months of 2016, government bond yields rose significantly. In the UK, the 10-year government bond yield ticked up from around 1.1 per cent to 1.4 per cent in mid-November.
The strongest rise has been seen in the US Treasury yield, as investors fear the longer-term result of president Trump's economic policies will be inflation and higher interest rates.
INTEREST RATE POLICY LIMITATIONS
While Trump's fiscal stimulus plan is more ambitious than those of his developed market peers, he is by no means alone in seeking to move away from interest rate policy as a tool to grow an economy.
Japanese policymakers have recently announced a ¥28.1 trillion (£193 billion) stimulus package aimed at dragging Japan out of long-term deflation. Closer to home, chancellor Philip Hammond promised a 'fiscal reset' in the Autumn Statement.
This suggests policymakers recognise the limitations of interest rate policy. Most of those who want to borrow have borrowed. While in theory rates could become negative - with savers charged for holding cash - this may simply drive people to put money under the bed.
This interest rate policy has supported the phenomenal bull run in bond markets that has seen yields fall (and prices rise), but it is difficult to see how it can run much further as political will evaporates.
John Pattullo, co-head of strategic fixed income at Henderson, says: 'We are sympathetic to the "stagflation" argument: there is a lack of productivity, digital disruption, both of which are supportive of a "lower for longer" interest rate scenario; but Trump's election has brought regime change, and the market is adjusting. Any rational fixed-income manager needs to respect that.'
Certain assets are more vulnerable than others to this change in direction. For example, those bonds where the price is more sensitive to interest rates - usually those with the longest time to maturity - will be affected more.
This is already being seen, with longer-dated gilts selling off significantly more than two- and three-year gilts in the recent bond market rout.
This has seen many managers skew their portfolios towards shorter-dated bonds. This may mean sacrificing some income, as long-dated bonds tend to pay a little more, but managers see this as a small price to pay for reducing vulnerability to higher interest rates.
For example, Richard Woolnough, manager of the M&G Optimal Income fund, favours short-dated bonds, anticipating rising rates. He has even added limited equity exposure in his portfolio to protect against rising inflation.
Equally, government bonds are more vulnerable than corporate bonds. The prices of corporate bonds, particularly at the higher-risk end, tend to be governed more by the fortunes of the issuing company than by macroeconomic factors such as interest rates and inflation, which affect government bonds more strongly.
As a result, most managers are putting their weight behind corporate bonds rather than government bonds. However, the type of corporate bond exposure undertaken varies from manager to manager.
For example, Pattullo favours the higher-yielding end of the market, Woolnough likes technology, media and telecom companies, while Rhys Petheram, manager of the Jupiter Corporate Bond and Distribution funds, is sticking with higher-quality bonds, believing that investors are not being sufficiently rewarded for moving into higher-risk bonds.
In spite of the gloom, relatively few voices are predicting a disaster in the bond market. Certain factors are still holding back economic growth, which in turn should help to dampen inflation and limit the fall in bond prices.
Petheram points to high government debt, problems in the European banking sector and the very real risk that Trump's policies damage the global economy. There is a theory that the US may 'steal' growth from other countries, without raising aggregate global growth.
He says: 'These are big structural drivers of deflation, and there are still significant tail risks.' This suggests any meaningful long-term hike in interest rates could be some way off, with monetary policy likely to remain supportive of the bond market.
Pattullo agrees. He says: 'I am sceptical that Trump's policies can generate a huge amount of sustainable growth.' He points out that even the most bullish analysts are predicting US growth of just 2.5-3 per cent.
Even if Trump manages to engineer his fiscal stimulus, most commentators do not expect growth to surge. Of course, it is not clear that Trump will be able to enact a stimulus.
Pattullo adds: 'The bond vigilantes and Congress may dampen his expansion plans. He may not be able to borrow trillions of dollars to spend as he wishes.'
Elsewhere, plans for infrastructure spending may be fine in theory but tricky to enact in practice.
Pattullo points out that just €12 billion (£10 billion) of the €320 billion committed for eurozone infrastructure spending has been spent. Moreover, the UK government may be running out of projects. This is likely to contain inflation.
It is worth remembering too that governments have a strong vested interest in keeping bond yields relatively low. They often have huge debt commitments, which could rise considerably if bond yields tick higher.
This is why Hammond has been keen to reassure markets that any fiscal reset does not mean losing sight of the long-term goal of balancing the UK's books.
There is a point at which government bond yields will become attractive once again. Investors have grown used to a world where they can get a higher income on stock market investments than they can achieve from government bonds, but historically this has seldom been the case.
The low yields available on government bonds have pushed some investors reluctantly into the stock market in search of income when they would far rather be in bond markets.
These investors are likely to swing away from the stock market back to bonds if yields become attractive again.
Where does that leave bond investors? David Jane, multi-asset fund manager at Miton, says investors need to ask themselves what the lowest-risk ways of generating an income are.
He adds: 'The problem with bond markets for some time has been that the upside is almost zero, but the downside risk is quite high.
'Yields need to compensate investors for price volatility. If a government bond is yielding 0.5 per cent, an investor receives a 5 per cent return over 10 years.
'If the price then moves 30 per cent in six months - as has happened at points this year - investors may be justified in thinking they are not being well compensated for volatility.' He still believes the stock market offers better prospects, as investors can get a dividend and capital growth.
That said, if fixed income continues to fall in price, it may once again hit a point where the income it offers looks attractive relative to the stock market.
Woolnough points out that bull markets tend to last far longer than bear markets. Falls are rapid, but the market can turn quickly. Investors just need to wait for the right moment.
HOW TO BUY THE ASSET
Whichever way Trumponomics plays out, it seems likely that the best days for fixed income are over for the time being. That's an argument for investing in funds with a more flexible mandate, and possibly investment trusts that can better manage the liquidity problems the sector is prone to.
The strategic bond sector is a good hunting ground. Managers have the flexibility to seek out those parts of the bond market that offer the best value - corporate or government, long-dated or short-dated, higher yield or investment grade.
It may not be the best time to consider a passive fund, with market volatility so high. But ETFs such as the Vanguard Global Bond index fund offer diversified fixed-income exposure at relatively low cost.