Interest rates to remain low, volatility high and deflation a real risk

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, says Head of Government Bonds for Threadneedle, Quentin Fitzsimmons.

"With high levels of market volatility continuing to persist, we foresee a significant range of investment opportunities, as lower bond yields result in capital gains and income enhancement." he said. "In fact, 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. "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." said Mr Fitzsimmons.

Overall, Threadneedle continues to believe that:

Interest rates will remain low for a considerable period and quantitative easing will be required some time to come.

Inflation is not an issue but the risk of deflation is high

Stock specific risk in credit remains very high

Strategies using liquid instruments remain desirable

Looking forward, Mr Fitzsimmons commented, "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.

"We are overweight credit especially high yield, but the rally in spreads is starting to look mature. However, government bank guaranteed debt, a new asset class as a result of the credit crunch, offers extra yield over governments at no extra risk."

"The US dollar is likely to continue do well given better stimulus and recovery in stocks and short dated credit spreads are very attractive as a balanced way of maintaining credit quality."

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

"Strategically, we need to consider how to tilt our investments towards higher spread opportunities." he continued. "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."

For more information, visit threadneedle.co.uk