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Rate rise and the bond bull

As we head into 2016, the slowdown in China and uncertainty over central bank policy will continue to play a significant role in investor thinking – not to mention the possibility of a ‘Brexit’.

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Recent events serve as a timely reminder of the fragility of the global financial system. As we head into 2016, the slowdown in China and uncertainty over central bank policy will continue to play a significant role in investor thinking – not to mention the possibility of a ‘Brexit’, which will garner more attention in the coming year.

Given the number of headwinds in play, it takes very little to trigger a turn in market sentiment and I think we could see more regular bouts of volatility going forward. There will of course be periods where asset classes move together, but the diversification benefit of bonds should continue – as the investment grade corporate markets are still more likely to be driven by growth and inflation expectations over the longer term.

Lower for longer

While the global economic outlook remains subdued, it is clear the Federal Reserve and Bank of England are uncomfortable running interest rates at record lows – they have been pegged at these levels for 7 years now and are causing capital allocation inefficiencies, distortions in asset markets and an ever widening wealth divide. The main issue is that global growth and inflation have continued trending down, but also the US and the UK have a high level of debt which makes both economies very sensitive to changes in interest rate expectations.

I would expect any interest rate rises to be well telegraphed, accompanied by a dovish stance and ultimately gradual in nature. This is in keeping with the underlying structural debt issue, as well as my base case that the low growth and low inflation environment is here to stay for a while yet.

Selectivity is key

Investment grade corporates, in particular, are attractively valued with spreads almost pricing in recession type levels. However, I do expect default rates to pick up - corporate leverage has risen as companies have taken advantage of low yields to lever up to buy back shares or for mergers and acquisitions activity. This reinforces the need to remain selective in my view – even if there is a good chance that spreads could tighten from current levels. Striking the right balance between yield and liquidity will also remain extremely important in the coming year.

Looking forward, given the low base level for yields, I do believe bond returns will be lower than we have been used to over the last 5 to 10 years. My base case for 2016 would be for mid-to-low single digit returns from investment grade corporate bonds. However, this is still positive in real terms and I do feel that bonds will continue to play a key role in smoothing out volatility in investors’ portfolios and working well as equity diversifiers.

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The views expressed by external contributors are not necessarily those of Old Mutual Wealth or Old Mutual International.

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