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Fixed income investors cannot be as passive in the near future, say Schroders

12th June 2014 Print

Investors in fixed income cannot be as passive in the coming years as they could be throughout 2012 and 2013 according to Gareth Isaac, co-manager of the Schroder Strategic Bond Fund.

Isaac, who manages the fund alongside Bob Jolly, says bond funds in general have prospered in the past two years, as bond markets have benefited from factors such as falling bond yields and lower government bond yields. However, he believes the environment has changed and that these factors can no longer be relied upon to continue to generate returns to the same degree.
“Credit spreads, the difference between yields on treasury and non-treasury bonds, have contracted steadily for 12 months, and are now looking very tight. European peripheral government debt and high yield bonds for example look priced for perfection and we are wary of how narrow the margin for error has become. The remaining return for holding these assets now lies in the carry - the returns generated simply by holding bonds. However, we think this is a risky way of generating returns as it involves an assumption that the market is pricing these assets correctly. We believe that bonds have risen to the point that further real returns will be limited. Bonds will still be well supported for the year, but if volatility does pick up, active investors will generate outperformance.”
Isaac does expect volatility to pick up in the second half of this year and as a result has made steps to reduce his risk position in the portfolio to give him flexibility to take advantage of any short-term opportunities.
“We are not bond bears; we believe that the technical environment for bonds will remain supportive. However, we expect volatility to pick up in the remainder of the year and we want to be free to capitalise on any short term weakness.” he explains.
Isaac believes the expected rise in volatility will come from a number of factors, highlighting political uncertainty amongst these. 
“Chinese credit markets have expanded at an incredible rate in recent years, and although the government has now taken steps to deflate the bubble, investors cannot know how smoothly this process will go. We are also wary of the threat which government bond yields represent. Rising government bond yields will place considerable pressure on credit markets and investors need to be aware of how sensitive their portfolios are to this. Markets have also been very composed in the face of the Ukraine crisis so far, but we are mindful of the fact that the situation is not yet resolved and could introduce volatility extremely quickly if relations deteriorate. Finally, the eurozone is still in the process of deleveraging, and a way behind the US and the UK in this process. If the European Central Bank does not find a way to stimulate growth and break the disinflationary cycle, the debt levels of many European countries may become unsustainable,” he explains.