Bond markets have experienced a mixed start to 2011. Against a backdrop of rallying equity markets and rising inflation, government bond yields have risen significantly. At the same time, global high-yield markets have delivered some pretty decent returns.
As economies continue their recovery, we expect these trends to continue during the year. That said, we expect plenty of volatility before we get to the end of the year.
In many ways, markets look as if they may have priced in much of the recovery already. But conditions remain choppy. There are still problems in continental Europe – particularly the so-called peripheral nations. The US housing market remains troubled. Most recently, political tensions have bubbled to the surface in North Africa and the Middle East.
All this means investors still have plenty to worry about but also plenty of opportunities to invest at attractive valuations.
The last few months have presented us with some good money-making opportunities, especially in flexible funds such as the strategic bond fund. One of our favourite trades has been to take advan-tage of higher inflation both in the UK and other areas of the developed world.
We have been of the opinion for some time that the market’s expectations for inflation have been too low. As a result, we have favoured investing in index-linked bonds rather than conven-tional government bonds. We have played this trade in France, Australia, Japan and the UK. As the market’s inflation expectations have risen, this trade has become less compelling. Nevertheless, it still has value in Japan and the UK, where retail price inflation is likely to remain high for the rest of the year.
Another key area is the high- yield market. High yield has enjoyed a fabulous run in the past couple of years and there is every reason to expect this to endure. In the positive economic environment that we expect, we believe this asset will continue to outperform investment grade credit, as with the latter, higher government bond yields will limit total returns.
A gradual recovery, coupled with improved opportunities for refinancing debt, mean the fundamentals are still positive. As a result, we expect returns for the year to be over 6 per cent.
That said, given the strength of the performance of high yield so far this year, we believe that the time is right to book some profits.
The economic recovery is progressing as expected so far but there are still areas of concern. Furthermore, we cannot help feeling that there is some overconfidence around. If you take into account that riskier asset classes have been benefiting from massive stimulus, which may be withdrawn soon, some caution is sensible.
Accordingly, it feels like the right time to take some profits in risky assets such as high yield. Given current valuations, we have reduced our allo- cation to this asset class in our strategic bond fund to around 25 per cent from almost 40 per cent at the turn of the year.
In the medium to long term, high yield will be a favoured asset class and the fund’s allocation could easily be back to 40 or 50 per cent by the middle of the year.
In the meantime, we feel that there is better value in the near term to be had from government bonds, index-linked assets and investment-grade corporate bonds.
Roger Webb is head of retail credit at Scottish Widows Investment Partnership