Being underweight bonds has been a popular trade among multi-asset fund managers and market commentators alike and over the last 18 months it has been a pretty good call.
While the bond market – as represented below by the Bloomberg Barclays Global Aggregate index – was a strong performer for much of the post-financial crisis period, it has struggled more recently.
Indeed, over the past three years the index has returned 23.02 per cent compared with the MSCI AC World benchmark, which is up by 67.78 per cent.
Performance of indices over 3yrs
Source: FE Analytics
Yet, since the start of 2017 the bond index has lost 39 basis points while equities have gained 22.31 per cent.
Much of this has swung on sentiment over how far central banks (and in particular the US Federal Reserve) will raise interest rates.
Last month the central bank rose rates to 2.25 per cent and Hargreaves Lansdown research director Mark Dampier believes there will be another rate hike this year.
However, unlike many industry commentators who believe that the Fed will raise rates as high as 3 per cent in the coming years, he said that they will likely stop sooner.
This belief contradicts testimony from the most recent meeting of the Federal Open Market Committee, which suggests that they will continue to raise rates into next year.
“I am not that bearish on bonds on the view that I don’t think interest rates will go up much more,” Dampier explained. “I don’t see them going up here in the UK and maybe they move a couple more times in the US.
“The US is more advanced than anywhere else but, by God, they’re going to produce a pretty big gap between them and everyone else.”
Yet, he said that the call to raise rates is ‘on a knife edge’, although the general consensus remains very much tilted towards three or four interest rate hikes next year.
If the Fed does choose to do this, he said the market is “odds-on” to have a recession in 2020 as the pace of growth is not strong enough to withstand such aggressive tightening – even with recent tax cuts and other fiscal stimulus measures from president Donald Trump. 
“Do I know that for sure?” Dampier (pictured) asked. “No, I don’t. Maybe the economy is stronger than everyone thinks but I don’t think the world economy is that brilliant.
“I don’t think it will take much with demographics, technology and private debt bearing down on all these things for the interest rates to start slowing these things down more markedly all of a sudden.”
However, he said it does not feel that way now, with the market not respecting this as a possible outcome, although he noted that it never does until it is too late.
If the market does go into a recession, investors will want to make a distinction between corporate bonds where the credit risk is much higher.
Indeed, a recession isn’t great for corporate bonds unless they are at the top of the investment grade sector as default rates rise and yields tend to expand.
Conversely government bonds don’t have the same problem, meaning that investors will want to have a higher allocation.
Yet, with rates rising, timing this switch will be important.
“It is a really interesting time,” he said. “And if you think that is wrong and inflation starts to rip then all bets are off because bond yields will spike up a lot more and there will be a hit to the equity market as well.”
When it comes to current asset allocation, he said that US Treasuries, which are yielding more than 3 per cent, look attractive on a relative basis to UK corporate bonds (for example), which is also paying around 3 per cent despite the additional credit risk.
However, the key with a trade such as this is currency. The dollar has risen strongly in recent months and any reverse of this could mean investors lose out on a real return basis.
“Three per cent isn’t a big coupon if the dollar swings 5 or 6 per cent the other way,” he said, noting that such a move could come about from the binary outcome of Brexit.
“All the bets are against sterling – and that might win out – but if it doesn’t you could see sterling go back up to $1.40 and that would rather wipe out things the other way,” Dampier said.
Rather than taking on the decision yourself, the Hargreaves Lansdown research director said investors could look to a strategic bond manager to navigate the next few years for them.
“Bond management seems to be so much macro and I think it is really difficult to call that and get that right consistently - especially now. It looks really cloudy,” Dampier said.
One fund he recommends is the £3.9bn Jupiter Strategic Bond fund run by FE Alpha Manager Ariel Bezalel.
Although it has endured a “sticky” time more recently – losing 38 basis points over the last 12 months – over the past decade it has been the third-best performer in the IA Sterling Strategic Bond sector, returning 124.72 per cent.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
“It is one of the reasons that the Jupiter share price has been struggling a bit – because a lot of money has been coming out of the fixed interest franchise but I would still back him,” said Dampier. “It is a proper strategic bond fund.
“Bezalel thinks that, actually, the US economy will start slowing down as it won’t be able to withstand too much on interest rates. He may be right but it doesn’t mean the Fed won’t raise rates a couple more times and overdo it.”
The fund is long on Treasuries, with 38.1 per cent of the portfolio in government bonds and five of its top 10 holdings in US Treasuries, although slightly more than half of the portfolio is made up of long corporate bond exposure.
The fund has a yield of 3.6 per cent and a clean ongoing charges figure (OCF) of 0.73 per cent.
Dampier said for investors wanting bond exposure it might be prudent to buy two or three of these strategic strategies because not all managers will get it right.
Another option he recommended was FE Alpha Manager Richard Woolnough who runs the £23.8bn M&G Optimal Income fund alongside deputy Stefan Isaacs.
It is mostly weighted to government and investment grade corporate bonds and the manager runs the portfolio from a top-down macro perspective.
The fund has a yield of 2.33 per cent and an OCF of 0.91 per cent.