It is difficult to make a case that developed market government bonds look good value. After its outperformance in 2011, over April and May the gilt market has resumed strength, with yields on the ten-year bond falling to just 1.54% from 2% a month ago.

Other perceived safe havens such as bunds and treasuries have seen similar yield compression. Liquidity, fear and policy intervention are all combining to support yields at their current level, all factors that could disappear with relatively little warning.

Yet a number of bond fund managers suggest yields on developed market government debt – including gilts – could go lower still. Notably Mike Riddell, manager of the M&G International Bond Fund, has suggested investors should not be betting against further falls in yields in certain parts of the government bond market with China and emerging markets growing risks for the global economy.

Artificial inflation

He says China’s government has been artificially inflating economic growth through credit growth to keep its population supportive.
“The IMF identifies certain conditions for difficulties – significant credit growth and a rapid increase in real estate prices. China ticks all these boxes and its credit growth in particular is off the charts.”

He also points to a phenomenon called the ‘Lewis turning point’, identified by Arthur Lewis in his studies on Japan. This is when a successful manufacturing economy starts to see significant rises in wages and therefore loses its competitiveness.

Riddell also highlights difficulties in emerging market debt. The percentage held by foreign owners has soared and this capital, he says, is less ‘sticky’ than domestic flows and can exit quickly, leaving economies in real peril.

In the meantime, the situation in developed market economies looks increasingly perilous. Respected economists Carmen Reinhart and Ken Rogoff’s theory is that once economies reach a certain level of debt it becomes impossible to grow: “Our empirical research on the history of financial crises and the relationship between growth and public liabilities supports the view that current debt trajectories are a risk to long-term growth and stability, with many advanced economies already reaching or exceeding the important marker of 90% of GDP.”

Gilt performance

All these factors are likely to continue to contribute to the crisis in the global economy, making further monetary easing by governments more likely, plus a further flight to quality from investors.

The recent performance of gilts has supported this view. Few, if any, investors saw value in gilts as recently as a couple of months ago, yet they remain the top-performing asset class of April and May.

Riddell believes financial repression means real yields can become much more negative and he remains heavily invested in global inflation-linked bonds.

Trends and friends

These views have found resonance among some multi-managers. Richard Phibin, independent funds consultant, says: “It has been argued that ‘the trend is your friend’ and certainly investors should be wary of betting against someone who owns 30% of the market – as the UK Government does with the gilt market. If the Government needs more money, it will get some.”

Tim Cockerill, head of collectives at Rowan Dartington, agrees the situation in emerging markets is worrying. He believes emerging market bonds are starting to be seen as a ‘safe haven’, saying: “We are in a situation where areas that are perceived to be secure are still quite highly valued and may not deliver the returns people expect.”

Cockerill suggests all the factors supporting EM bonds – strong relative growth, good demographics, low debt levels – are already in the price. He points out that in Brazil, the currency has depreciated quite sharply as the central bank has cut interest rates. They are aware of the ‘hot money’ that has flowed into local currency debt and are striving to weaken the currency.

Equally, credit has surged in the past few years and the culture of moderation around personal debt is evaporating rapidly. If foreign investors withdraw their support for emerging market debt, it could be very destabilising for these bond markets and, by extension, the global economy.

EM debt support

But how widely accepted is this view? Riddell’s bearishness may have spooked investors, but many multi-managers are avoiding government bonds and are still supportive of EM debt.

For example, Gavin Haynes, investment director at Whitechurch Securities, says emerging debt markets are growing in stature. He adds: “Emerging market debt also offers potential for appreciating currencies, relatively solid yields of 6% to 7%, healthier balance sheets and less concern over the sovereign debt issues plaguing Western economies.”

He holds very little exposure to gilts.

John Husselbee, managing director at North Investment Partners, agrees, saying the negative real yield in gilts makes them unattractive even if they can go lower. He suggests the downside risk is far higher than the upside potential, and as a result this is the one area where he has low exposure across his portfolios.

Both prefer to invest in corporate bonds.

High yield value

Haynes believes high yield bonds in particular look good value, adding: “We are reassured that traditionally cautious bond fund managers are positive on the opportunities in this area of the asset class.”

However, he agrees it is prudent to hold some inflation-linked bonds and holds positions in the M&G UK Inflation Linked Corporate Bond Fund for that purpose.

He suggests the corporate bond market is reaping the benefit of multinational companies having gone through three years of cost-cutting and now having solid cash flows. In some cases, their balance sheets now look to be in better health than some large Western economies.

Pricing support

The lack of issuance in corporate bond markets is currently supportive of prices. Higher-quality corporates have largely locked in lower interest rates, have widely deleveraged and do not need to come back to bond markets. Therefore, volumes are low relative to history and this lack of supply has kept the market strong.

Husselbee believes there is value in quality corporate credit and also has a small percentage in high yield across his funds.
However, he adds that – as a response to the current problems in fixed income markets – he is short duration and is looking for liquid funds, believing liquidity in bond markets remains a challenge.

Jason Whitcombe, an adviser with Evolve Financial Planning agrees, saying the majority of his fixed income exposure is in short-dated, high-quality funds.