We expect higher yields on US, European, UK and Japanese government bonds, but the rise in yields is likely to be relatively modest, in our view, and will depend on economic data. There are pockets of opportunity within credit, but we have a generally more cautious stance than in the past and will likely prefer euro-denominated assets to dollar assets, since the risk of interest rate rises is potentially higher in the US.
From a global asset allocation perspective, boosting yield is likely to mean having some exposure to peripheral Europe and high yield, with emerging markets adding diversification.
Europe: positive on periphery
Our preference is to be positive on peripheral government bonds and more negative on the core of Germany and France as we think that peripheral European government bonds still offer attractive yields relative to macro and systemic risks. Geographically, we see gilts being the worst performer because of the long duration notion of the UK market. Strong UK data will test the Bank of England’s monetary stance and yields will be sensitive to this.
EMs: mixed, but hard currency corporate debt attractive
The macro outlook for emerging markets is mixed. According to our group’s chief economist growth is expected to rise to between 5.1% and 5.3% (from 4.7%) in 2014. We believe sentiment towards the asset class will depend on policymakers being able to control inflation and current account deficits.
Local currency markets look volatile, but in many cases the valuations of hard currency corporate assets in emerging markets are better than similar rated developed market credits. We are more positive on corporate debt than sovereign. The market absorbed more than $300bn of issuance in 2013 and institutional investor appetite is steadily growing.
High yield: neutral impact of improving economy
We have a positive view on the global economy but this is something of a neutral for high yield. An improved operating environment should support corporate balance sheets, but there is also the potential for increased leverage and higher funding costs if core yields rise. We expect stronger returns from high yield than other fixed income sectors and remain overweight.
Valuations are less attractive, with US high yield spreads down to 400bp and euro high yield spreads at 350bp. Flows into high yield are strong and technical factors are supportive, however investors should be mindful of duration exposure and credit quality, as well as the risks of higher yields and deteriorating covenants.
Inflation-linked bonds: upside inflation risks in medium term
We see valuation as a key driver of some improvement in addition to some renewed upward drift in actual inflation rates. In the UK we prefer to be long the inflation break even spreads as UK inflation remains more stubborn than elsewhere. In the eurozone the poor performance of inflation has led us to prefer to be underweight at the short end of the yield curve and to try to boost carry by adding Italian inflation linked bonds. Increased inflation expectations look unlikely in the near term but over the course of 2014 rising Break-even Inflations and higher inflation accrual could become the key drivers of Inflation linked bond returns.
What will be the best performing fixed income sector?
In each of the past 13 years at least one fixed income sector has delivered more than 10% annual returns, even in an era of declining interest rates and government debt stresses, although past performance is, of course, no guide to future performance.
Over the past two years, high yield has led the way – indeed in four out of the past five years this has been the case – in line with the strong performance of global equities.
In our view, QE was responsible for much of this. In 2014 we will see the transition from QE to forward guidance as the key monetary policy regime and this could be a risk to the ongoing strong performance of high yield and equities. Indeed, it is hard to see high yield delivering 10% returns again, given the low level of yields and the required decline in yield that would be required to generate a strong capital return.
While our central scenario is for liquidity to remain plentiful, for growth to improve and for central banks to keep interest rates on hold, the risk scenario is that there is a big risk-off event and government bonds – or more likely – inflation-linked bonds (one of last year’s poor performers) will deliver returns that most investors currently don’t expect.
