Chris Iggo, senior strategist, UK, at AXA Investment Management, observes that ‘Bond markets have fully priced in the beginning of a monetary tightening cycle beginning before the end of this year. This is in response to the obvious increase in anxiety about global inflation being felt by central bankers who now appear to be less comfortable with the view that what we are seeing is just an inflation hump.

‘While many investors will still find it hard to imagine that interest rates will be going up before the full implications of the credit crunch have been felt, it is dangerous to ignore the central bank mantra. That is, if the hard-won gains to achieve long-term stable inflationary expectations are to be secured, action may have to be taken today to prevent the significant inflation shock becoming embedded in economic behaviour.’

Bonds under pressure
Iggo points out that, as a consequence of this thinking ‘in the UK, two-year government bond yields have risen from a low of 3.7 per cent on 1 March to 5.5 per cent by mid June – a fall in bond prices of 3.63 per cent. Further out on the maturity curve, yields have also risen, with the benchmark ten-year government bond yield rising by one per cent over the same period to a current level of 5.2 per cent – a capital loss of seven per cent.

‘Generally, the macro environment does not make for happy times for investors. Over the year to date, returns from equities have been minus eight per cent, while returns from government bonds have been minus three per cent. Property returns are also negative for the year, while corporate bonds have not recovered from the massive widening in credit spreads that occurred last year. The only “asset” class to deliver strong positive returns has been commodities, followed by inflation-linked bonds. With news that Chinese imports were up 40 per cent year on year in May, these inflationary trends are likely to be with us for some time.’

Wider corporate spreads
Looking at conditions in the corporate bond market, Fatima Luis, manager of the F&C Strategic Bond Fund, points out that ‘Spiralling oil, energy and food prices are just some of the factors that have put inflation at the forefront of concerns for central bankers. For the Bank of England in particular,  further cuts, which were being urged by retailers not long ago, seem a distant prospect.

The outlook of rising rates on deposits has had a punishing impact on investment-grade bonds as capital values have dropped to accommodate widening spreads and rising yields. While many retail investors naturally see investment-grade corporate bonds as a safe port in a storm, I believe that high-yield credits may be better positioned to withstand higher inflation for the time being. We are, therefore, retaining a 37.5 per cent exposure to high-yield bonds in the Strategic Bond Fund, in the belief that prices are already factoring potential rises in defaults.

‘As this adjustment in expectations works through, we believe credit spreads will offer a once-in-a-cycle opportunity to get into the asset class at very attractive levels. However, we think in the short term things will remain challenging. When the time is right we expect to move  aggressively. We are currently holding 13.2 per cent of the fund in floating-rate notes, close to the highest levels we have had in the fund. These tend to perform well in a rising yield environment. Additionally we have shortened the duration profile on the fund to 3.8 years and have raised cash weightings to 8.8 per cent.’