Jonathan Platt, head of fixed interest at RLAM, assesses the challenges facing bond markets in 2010 and highlights the opportunities available in certain asset backed bonds.

Bond markets face a series of challenges in 2010. The first issue is how markets will cope with the end of Quantitative Easing – we expect this to happen in Q1 2010 and to lead to higher government yields (0.5-0.75bps) on ten-year gilts. More importantly, the direction of yields in the medium term will depend on the prospect of global economic recovery.

We believe that growth is now set to improve and that deflation will not be an issue for markets. Overall, we target ten-year UK government yields at 4.75 per cent by the end of next year.

Recent talk of government indebtedness has focused some attention on the state of UK finances. Whilst our forecasts do not envisage a sterling crisis the dependence of the UK upon external financing does pose risks – especially if the chances of a hung parliament increase. Real yields look expensive on a global basis – particularly in the UK - and we expect to see higher index linked yields through 2010. We continue to view currency hedged overseas government markets as more attractive than the UK.

Credit markets have recorded outstanding returns in 2009. Higher government bond yields will be a negative for credit in 2010 but we still see significant scope for credit outperformance of government debt. We expect credit spreads to fall a further 0.5-0.75 per cent over the next twelve months and believe that credit is capable of 3% p.a. excess return over the next three years.

The best value in credit lies in asset backed bonds – particularly in the senior tranches of debt. New innovations in financial debt (such as Lloyds ECNs) have polarised investors but we believe they are an important addition to our range of debt instruments and see good value opportunities in this area. We are cautious on economically sensitive issuers and continue to advocate a bias towards highly covenanted issues.