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David Absolon

2014 bond outlook

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David Absolon (pictured), Investment Director at Heartwood Investment Management, examines the outlook for bonds in 2014…

Bond markets have enjoyed a bull run over the past 30 years, largely supported by both falling interest rates and inflation and, since 2008, loose monetary policy. But things began to change last summer as prices fell and yields started rising, and we expect this environment to continue in the coming year. Indeed, 2013 gave us only the third negative annual return for global bonds since 1987. The other two were 1994 and 1999.

What does the year ahead look like for bonds? Neither the US Federal Reserve nor the Bank of England is likely to raise interest rates from their all-time lows this year. That will be a discussion for 2015. What we do believe, however, is that the yield curve in isolation will continue to adjust towards a level that is more normal in historical terms.

The direct result of this will be higher bond yields and we see 10-year funding costs for the UK and US rising to the 3.5-3.75% level this year. If they move any higher than this, it is likely that central banks will feel the need to intervene and keep yields at bay for fear of choking off the economic recovery.

We also expect the pace and volatility of rising bond yields this year to be less aggressive than we saw in 2013. A significant part of the excess overvaluation of government bonds was largely unwound last year when yields for US 10-year Treasuries moved to 3.0% from 1.6% as the market adjusted for a less active Federal Reserve.

More importantly, we do not see yields falling back to the lows that we saw in the past few years because we do not subscribe to the notion of a global deflationary environment. Inflation is often called the genie and deflation the ogre, but we do not believe that either will resurface this year.

While there is talk of possible deflation in Europe, this is not the case on a global level. Using the US as an example, consumer spending is on the increase again after years of deleveraging, unemployment is falling and wages are rising, albeit modestly. The bond yield rise that we anticipate goes hand in hand with an improving global growth background.

Some would argue that yields have moved up to levels that make a strong investment case for bonds, but we do not believe that they have reached that point yet. However, they look more attractive than 12 months ago and we would consider buying at yields below what is historically considered to suggest fair value, given the benign inflation environment.

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