Central banks are likely to take centre stage again next year but bond investors are split on where best to find value.
Traditionally, bonds trade in relations to two things, interest rates and inflation, and both are expected to be a big factor again in 2017.
Normally if inflation is higher it is a signal that an economy is strong, suggesting a rallying equity market. If economies are strong then central banks are likely to raise interest rates as a strategy used to stop them overheating.
After a decade of low and falling interest rates where global growth has been slow to pick up, 2017 saw the reverse of this trend with the Federal Reserve in the US raising rates three times.
Source: Trading Economics
In the UK, inflation bubbled over 3 per cent resulting in the Bank of England (BoE) raising interest rates sooner than markets had previously expected in November.
As well as this, the withdrawal of the quantitative easing (QE) measures by the Fed and the slowdown of such measures by the European Central Bank (ECB) are also expected to impact markets.
Analysts at Whitechurch Securities said: “We believe that interest rate policies both at home and overseas will be key in dictating how investment markets perform in 2018.”
Unlike unpredictable political leaders, central bankers are expected to act in a much more measured way and communicate their intentions clearly so as to not surprise investment markets, they added, with the withdrawal of QE likely to be a long process.
“We see little value in holding highly interest rate sensitive assets that have benefited from loose monetary policies and have been the star performers in the low interest rate environment,” Whitechurch Securities said.
“The risk however, is if they move too slowly, economies may overheat and inflation rears its head.”
So what should investors do in this environment and is there any chance of making a decent return from bonds next year?
Schroders global credit fund manager Rick Rezek said valuations are looking stretched and therefore he is taking a more defensive position in his global bond funds.
As well as central bank stimulus, he noted that for the first time since the financial crisis a decade ago, there is now synchronised growth in economic activity from most of the major developed market economies.
“This, coupled with recoveries in certain emerging markets, has underpinned a solid pick-up in corporate revenues and earnings across regions,” he said.
“Assessing the viability of these two factors going into 2018 will be important determinants of portfolio positioning. We believe that valuations across the major credit markets are quite stretched and we close 2017 more defensively positioned than at the beginning of the year.”
The manager of the Schroder ISF Global Corporate Bond fund added: “While we believe that economic activity should remain on a solid footing into the new year, the margin for error reflected in current valuations warrants a great deal of caution.”
FE Alpha Manager Ariel Bezalel, head of fixed income strategy at Jupiter, noted that he is also reducing risk in his £3.8bn Jupiter Strategic Bond fund.
Performance of fund vs sector since launch
Source: FE Analytics
“Speaking as a global bond investor, unwinding the biggest monetary policy experiment in history in conjunction with raising interest rates – at this late stage in the economic cycle – signals a significant risk,” he said.
“In bond markets during 2017, we witnessed some striking warning signs of potential asset bubbles created by such loose policy.”
These included the fact that European high yield credit traded in line with US treasuries for the first time in history; Argentina sold oversubscribed 100-year bonds despite being a serial defaulter; and, in what is usually a sign of a slowdown, the US yield curve flattened – despite improving GDP growth, raising questions of whether the yield curve is also distorted.
As such, Bezalel said that caution is the most sensible approach, noting that he has increased the quality of bonds in the portfolio and reduced high yield exposure.
“While we favour high quality, developed market government bonds at the moment, such as US treasuries, we do see a few bright spots in emerging market debt,” he added.
“We have also put money to work in bonds which act as cash proxies, where we believe there is a reasonable possibility of better returns without putting the capital invested at undue risk. At this advanced stage of the credit cycle, we believe these are right strategies for 2018.”
Invesco Perpetual’s Paul Read (pictured) and Julien Eberhardt agreed that caution is the right way to approach the market but added that they are still finding opportunities in certain pockets. 
Their portfolio performed well in 2017 but the managers of the €2.8bn Invesco Euro Corporate Bond fund warned that it is difficult to see bond markets repeating the kind of performance seen in 2017.
In particular European bond markets are now looking expensive, the duo said.
“Our strategy is to seek out relatively ‘safe’ sources of income while staying defensive overall and periods of market strength provide the opportunity to reduce exposure and wait for better levels at which to add,” they said.
However, there are still come areas of the market they have found value, including corporate debt from financials.
The managers said: “From a fundamental perspective, banks remain in a strong position. The bailout and rescues of the past year have removed weaker banks, leaving a stronger financial sector overall.
“Tighter monetary policy and steeper yield curves should, all else being equal, also be supportive of the sector.
“However, from a valuation perspective the outlook for the sector, like much of the corporate bond market, has become more balanced. There are still some opportunities, but we need to ensure that we are being rewarded for taking the risk.”
Analysts at Whitechurch Securities added that finding where the value in bond markets with a rising interest rate backdrop is one of the greatest challenge for investors next year.
“We don’t see bond prices collapsing. With economic growth fragile, high political uncertainty and inflationary pressure likely to subside, we see little scope for material increases in the UK and it may be a case of ‘one and done’ from the Bank of England,” they said.
“Going into 2018 we continue to prefer corporate bonds and particularly funds investing in special situations such as bonds of financial companies.
“We also believe that a global approach makes sense when investing in bond markets with economies at different states of the cycle.”