Government bonds will remain a major investment theme in the current economic environment as the extent of the global slowdown will continue to fuel the need for substantially lower interest rates.

According to Quentin Fitzsimmons, head of government bonds for Threadneedle, there is a significant range of investment opportunities, as lower bond yields result in capital gains and income enhancement.

He says, ‘Government bond yields look even more attractive after the equity rally. False liquidity has led to a chronic mis-pricing of risk in credit markets, and yield spreads have now begun to look interesting.’

Deleveraging in developed markets, a theme that dominated the financial markets last year, is still feeding through to individuals as these real economies remain depressed, making people's ability to borrow greatly constrained. Government bonds will remain a safe haven for investors until the deleveraging process has completed.

In this environment, the real issue is not inflation, but the increasing possibility of deflation.

Fitzsimmons adds, ‘Recession brings with it rising levels of spare capacity, weak wage bargaining, and potentially a period of much lower inflation than is currently consensus. We think that the risks of deflation are being underestimated.’

Looking forward, Fitzsimmons believes that, ‘Government bonds have sold off very significantly as investors run from very heavy supply and soaring deficits. The short-term picture for government bonds is therefore difficult. However, government bonds offer more value than many think.’

Taking a longer-term view, long-dated bonds are looking more attractive in the US and Europe because of the steepness of yield curves.

He adds, ‘Strategically, we need to consider how to tilt our investments towards higher spread opportunities. So far this has been done by extending the maturity of a proportion of the high-grade portfolio into government guaranteed issues.

‘Competitive devaluation policies will continue to occur, bringing considerable international political conflict and risk of protectionism. This brings forth opportunities in the currency markets, where overall uncertainty is high, requiring flexible and adaptable strategies. It is clearly impossible for all countries to export their way out of trouble by devaluing simultaneously.’

Further reading:

Fixed rte bonds: to fix or not to fix?