At the start of this year, most bond market investors would have staked their reputations on the under-performance of government bonds over the coming year. In the UK, with a yield of 3.5 per cent on a 10-year gilt and inflation running at close to 4 per cent, you would expect to see some very poor returns.
What has happened since has been startling. The FT-All Stocks Gilt index has produced a return of more than 4.5 per cent, matching that from European high-yield corporate bonds and exceeding the returns from most of the big equity markets.
The main government bond markets, with some notable Southern European exceptions, have been relatively good performers. A number of factors, including the Japanese earthquake, unrest in the Middle East, European deficits and the US debt ceiling, have led to heightened risk aversion. These are abnormal conditions and the impact of all these factors is leading investors to fear for the global economy.
In these circumstances, many investors have adopted positions that are short of interest rate risk (duration) due to the low-yield/highinflation environment. So far, this has proved costly.
The current environment seems to be one where capital preservation is the most prudent strategy, as we await the emergence of new opportunities. As yet, risk assets do not seem to have fully priced in the gravity of the situations we are facing. The US debt debacle, European austerity measures, interest rate rises and global inflation all represent big challenges.
In the UK, the scenario of slower growth and higher inflation appears to be accepted as the norm. As a result, we are adopting a cautious approach to our portfolios. Within the Swip strategic bond and absolute return bond funds, for instance, a diversified and active approach is paying dividends and we believe it will continue to do so.
Identifying some themes to play in this environment has helped significantly.
In corporate bond markets, for instance, we like price-makers over those that have to pass through higher prices to their customers. This leads us to commodity companies and other B2B industries.
Many investment-grade companies in these areas also have the added quality of strong balance sheets, following a period of strong cashflow generation and a cautious approach.
Another theme has been to avoid businesses with excessive exposure to the consumer, especially in peripheral Europe, the US and the UK where stress is acute.
We have also looked to profit from inflation, which remains problematic. We have capitalised on this trend via long positions in break-evens in a number of markets.
A vital theme is to stay liquid. The problems around the world will make for further volatile market conditions over the coming months. Some thoughtful position-taking is required, as is having the ability and conviction to take advantage of the opportunities that will doubtless emerge in risk assets over the coming months.
Roger Webb is head of retail credit at Swip