Portfolio Adviser • October 2016 • Counterpoint

Fixed income investors have accumulated some tremendous gains so far this year. At the of end August, the total return of the gilt market was 17.6%, while the sterling credit all maturities market returned 16.5% to 1 September, according to Bloomberg.

This year, globally, the asset class has not only delivered capital growth and income but it has also outperformed equity markets in the UK, Europe and even the US. This stellar performance has been driven by the fall in government bond yields and tighter credit spreads: a direct result of central bank bond buying and, in the case of the UK, additional monetary easing.

As many major central banks remain on the asset purchase path, the trends of lower yields and tighter spreads are likely to continue for now. But there are risks ahead, stemming from the fact the bond market is overvalued. Sustaining these attractive returns from fixed income will not be easy for investors.

The current bond market environment is almost completely controlled by central bankers, as they continue to struggle to stimulate growth and achieve inflation targets.

More recently, we saw the European Central Bank (ECB) disappoint markets by not announcing further stimulus measures.

The reality, however, is that the central bank continues to dominate, as its purchases of corporate bonds are putting downward pressure on credit spreads of both eligible and ineligible assets.

On the other hand, the Bank of England met market expectations with a package of measures after the UK’s vote to leave the European Union. We will soon see the bank join the credit party when it begins to purchase sterling corporate bonds, which would push sterling rates lower, eventually squeezing the UK corporate bond market in a similar way to that seen in Europe.

Across the pond there is continued uncertainty regarding the timing of the next Fed rate hike. Recent, softer economic data, and the conspicuous lack of guidance about a near-term rate hike, has pushed the market to speculate that the next move will happen in December.

Meanwhile, the Bank of Japan is undertaking a comprehensive review of its monetary policy measures.

With policymakers around the world continuing to face challenges, including weak growth, low productivity and deflation, policy and market rates are likely to be even lower, for longer.

The ‘lower for longer’ period has helped turn fixed income into one of the more attractive asset classes this year, not only for diversification purposes in an multi-asset portfolio but also for returns. Although the global policy backdrop shows no signs of any material change in the near future, there is enough talk of different policy directions for investors to understand that bonds will not stay at their current elevated levels forever.

Should central bank measures prove successful, global growth and inflation will pick up, which is likely to drive yields higher. On the other hand, growth could slow down and credit could sell off, or we may see a renewed sovereign crisis that would push credit spreads wider.

The recent wobbles in the bond market that saw yields rise and spreads widen due to investor jitters, served as a reminder of just how dependent markets and valuations are on extraordinary central bank policies.

Ultimately, markets will need to find a new equilibrium in a post-QE world when, presumably, growth and inflation are at more comfortable levels. In addition, we are likely to see higher volatility as a result of the return to normality.

Central banks will continue to dominate bond markets for the foreseeable future. Given this, our view is that rewards will be achieved by protecting portfolios from an unwelcome correction, rather than expecting continued, outsized gains.

By focusing on strategies that limit interest rate exposure and credit spread duration exposure, investors should be able to access the bond market through a less volatile channel.

If rates and yields eventually rise, bond funds that concentrate on the shorter end of the market can mitigate losses, as cashflows from maturing bonds are reinvested at higher yields.

Short-duration bond funds are also less sensitive to rate and credit spread movements compared with longer durations, implying less volatile returns than the broader market.

This is largely because shorter- duration bonds are, by definition, closer to maturity. They are, therefore, less susceptible to large swings in interest rates or credit spreads, making prices less volatile to changes in rates.

For investors, the prospect of rising yields, widening credit spreads and greater market volatility, makes a very compelling case for the features of short-duration portfolios.

With the impressive performance of fixed income witnessed so far this year, at risk of changing direction, the downside protection of short-duration portfolios can help mitigate losses, while still aiming to provide investors with income.