The outlook for bonds

Chris Higham

Chris oversees a range of bond funds including high-yield corporates, government and emerging markets bonds. He has managed Aviva Investors’ Strategic Bond Fund since it was formed in 2008.  An associate member of the UK Society of Investment Professionals and a CFA® charter holder, he has worked in the investment industry for 17 years.

 Conflicting forces are likely to influence bond markets this year. On the negative side, bonds appear very expensive after an unprecedented boom, which saw their price increase in many of the advanced economies for more than three decades. The taming of inflation and falling interest rates have driven this bull market, or period of sustained price rises. The good times continued for investors in 2016, with the price of government bonds ending the year higher (with the exception of a few emerging market economies). 

In recent years, highly supportive policies by central banks have further fuelled the rally. However, while policies are likely to remain helpful, they may not be as friendly to bond markets as in the past – and you should, of course, bear in mind that past performance isn’t a guide to what may happen in future. 

President Trump has pledged to cut taxes and increase government spending in areas such as infrastructure and defence. That is likely to boost inflation, placing pressure on the Federal Reserve, (the US central bank) to raise interest rates to contain the pace of price hikes. The bank has increased interest rates twice over the past fourteen months and higher interest rates spell bad news for bonds, which pay a fixed income and thus become less attractive to investors.

As economies improve, will central banks stay supportive?

But there are signs that economic growth is picking up around the world. Indeed, we believe that this year and next the global economy will expand at its fastest pace since 2011. The accompanying increase in inflationary pressures could force central banks elsewhere to rein in supportive policies more quickly than anticipated. 

There are also various reasons to be optimistic about the outlook for bonds. Firstly, it’s important to remember that many people have predicted the end of the long ‘bull market’ for many years: clearly those gloomy warnings proved wrong.

It looks likely that we’ll continue to see huge demand for government bonds from institutions such as pension funds. The uncertainties that have plagued the global economy in recent years, and prevented central banks from raising interest rates, also look set to continue. For instance, concerns about the long-term economic impact of the UK’s exit from the European Union may prevent the Bank of England from raising rates as quickly as elsewhere. Economically, the euro-zone remains weak and this year key elections in France and Germany pose significant political risks. Japan continues to face major economic challenges, while the US Congress may well water down Trump’s campaign pledges on lower taxes and more spending.

 

If interest rates stay low...

Overall, we do not expect inflation to become a problem globally, but rather for the fears of deflation, when prices in general fall on a sustained basis, to subside into the background. That means interest rates are likely to rise only gradually and remain well below what might be considered a normal level for many years to come. That outlook is encouraging for bond investors. 

There are also opportunities for professional investors, whose expertise can be accessed via a bond fund. Global central banks are likely to pursue divergent policies this year. Interest rates are likely to increase further in the US, but the prospect of a rate rise is weaker in the UK and they are unlikely to increase at all in the euro-zone or Japan. Skilled, nimble investors can profit from this contrasting outlook. There could also be opportunities among corporate bonds in the advanced economies and those issued by companies and governments in the emerging markets. 

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