Global economic data has been stronger than expected since the end of last year. The US economy is leading the way on this front, with encouraging signs coming from the labour market and from consumer spending; emerging market growth also appears to be stronger than thought a few months ago.
Even in the eurozone not all countries are experiencing recession. Germany, in particular, is growing at a pace that is not consistent with economic conditions in some of its smaller European trading partners.
The policy environment is also a longer-term concern for some bond investors and, of course, there remain numerous downside risks in the global economic outlook.
So what does this mean for bond investors?
For those exposed to a lot of interest rate risk it is clearly a negative for marked-to-market valuations of fixed income portfolios. As yields rise, prices fall. To mitigate this risk our preference is to have exposure to corporate credit risk.
If government bond yields are rising because of better economic conditions, this is clearly positive for companies and for the pricing of corporate debt. So an offset to higher bond yields will be narrower credit spreads.
In addition, we suggest short duration strategies, keeping exposure to corporate credit in exposure to maturities at the short end of the yield curve, below five years. In our view, this part of the market will not suffer as much from changes in longer-term yields but will provide investors with an income yield well above that available in government bonds or in cash.
The recent rise in bond yields may prove to be temporary – a short-term response to the easing of risk in Europe. However, it is more likely that we are currently seeing the normalisation of the structure of risk-free bond yields.
The risk profile in the interest rate outlook is not symmetric given how low rates have been. Investors should look to prepare for this inevitable development in global bond markets.
