Sarah Arkle, chief investment officer at Threadneedle Investments, observes that ‘Initial fears of rising inflation have been more than offset by the clear evidence that the US economy was slowing rapidly and that the Federal Reserve would cut interest rates again.’

She adds, ‘We started to add to our duration position again near the end of February. We continue to favour strategies that will work well if the Bank of England cuts interest rates.

‘Credit markets remain under pressure and spreads for investment grade and high yield continue to widen. We prefer the prospects for the former and believe that the default rates implied by current spreads are unlikely to be realised.’

Investec Asset Management’s bond team takes the view that ‘It is hard to justify the current pricing of US government bonds. Adjusted for the current core inflation rate, medium to longer-dated bond yields are already well below the levels seen in the past two recessions. Such valuation extremes look unsustainable on anything other than a relatively short time horizon and reflect the massive unwinding of credit risk playing out in fixed-income markets.’

Steeper yield curves
Investec also draws attention to the fact that ‘Aggressive policy action coupled with rising oil and food prices suggests that inflation expectations will increase. As a result, we continue to favour steeper yield curves and prefer inflation-protected securities to conventional bonds. Most other government bond markets are also expensive, albeit less so than the US, and typically price in more monetary easing than seems likely.

‘Non-government bonds are starting to look very cheap thanks to distressed selling. Investment-grade bonds are increasingly priced for depression rather than recession. After performing badly since last summer, these bonds should deliver attractive returns over the next 12 months. Only the lowest-rated segment of the high-yield market has
yet to sell off sufficiently to price in the potential downside risks to growth.’

Forced sellers
Robert Talbut, CIO at Royal London Asset Management, reports that its bond funds are looking to improve the credit quality of the corporate bond holdings: ‘Smart investors look at a range of assets and assess the different signals they are sending out. They can determine whether a particular asset is reacting to newsflow or behaving differently for no good reason. I’d suggest that the latter is happening at present and is, therefore, creating a good buying opportunity.

‘The corporate bond market has continued to sell off to fresh lows. Conditions within the corporate bond market are some of the worst that many can remember. The financial crisis is leading to intense technical stress and dislocations across credit markets as investors are forced to reduce risk.’

Talbut adds, ‘There appear to be many forced sellers and this may
have further to go as the process of de-leveraging continues across financial institutions. However, just as in 2003 when there were forced sellers of equities which created a good buying opportunity, I believe that similar stresses are creating great entry points into good quality investment-grade debt securities.’