Fixed-income investors are wrongly focusing on rising interest rates as the biggest potential headwind to their portfolios, according to several bond fund managers, who warn that ‘stickier-than-expected’ inflation will likely prove a far greater challenge to contend with.
Speaking at RSMR's latest Candid Conversations event, Simon Bond, who runs Columbia Threadneedle's £337m Social Bond fund, said widely held fears from clients that rates will rise is "the wrong way to think about" recent macroeconomic events and warned that "fear in the bond market should be filled with expectations of inflation".
"The shape of the yield curve will be affected by rising interest rates, or indeed cutting interest rates, but [bond managers] can cope with that reasonably easily - although it does shape how risk is balanced within a portfolio," he explained.
"In comparison to equities, risks are lower and returns are lower, but at the same time investors are getting absolutely nothing from cash. Meanwhile, coupons on fixed income are decent at the moment, even given low interest rates.
"Fixed income absolutely has a place within a balanced portfolio, but risks now are perhaps rising as expectations of inflation are coming through."
Sunil Krishnan, head of multi-asset funds at Aviva Investors, agreed there will "always be a role for bonds" across multi-asset portfolios, but warned that many funds targeting lower risk levels have a vast reliance on fixed income instruments and therefore a lack of asset class diversification during what could be a challenging time for bonds.
"We do need to question whether the range of potential outcomes [for fixed income] currently is a little different from what we have seen in the past," he reasoned. "This is not just in terms of what is coming through today in terms of inflationary data, but in terms of some of the underlying drivers such as incredibly strong private and public sector demand.
"It is that latter part that we simply haven't seen over the last 15 years, and I think [investors] need to consider these factors."
This view is shared by Alex Ralph, co-manager of the £1.8bn Artemis Strategic Bond fund, who warned some of the factors contributing towards inflation expectations "are not transitory".
"Yes, supply bottlenecks have caused temporary spikes in inflation; we saw that in the auto sector in the latest US inflation numbers," she said. "But, we do think that consumer inflationary expectations will continue to rise, and that rent will be the next factor that will cause US inflation to stay sticky.
"We are entering a new era where the labour market has more power, so we expect inflated wages to come through."
That said, the manager does not believe the UK will see the same rate of roaring inflation last experienced in the 1970s, given there were other factors at play at the time including oil price shocks and "a much more unionised workforce".
"We do think that we can use the yield curve, as Simon [Bond] mentioned, to protect ourselves against rising government bond yields," Ralph pointed out. "We also think that the central banks will be too late to raise rates, so we believe the yield curve will start steepening once more towards the end of the summer.
"Therefore, we have made sure that we are positioned away from the long end of the curve."
She added that, within the credit market, there are "lots of levers we can pull" to protect against inflation, including the use of floating rate notes and exposure to the financial sector, which tends to benefit from steepening yield curves.
Jim Smith, a vice-president of Brandywine Global Investment Management (Europe), argued that although there will "absolutely be inflation" over the near term as the world recovers from the pandemic, it is "too early to tell" whether this will remain the case over the longer term.
"Some of the longer term potential inflationary concerns are still here - such as technology, productivity, and demographics - while we are looking at other trends, including a nod down in credit impulse which can cause global growth to lag," he said.
"The biggest factor we are trying to get our heads around at the moment is the savings rate; there has been a $2.5trn increase in the US household savings rate and a $1trn increase in corporate savings - that is the equivalent of 16% of US GDP."
In terms of what may unfold in the future, Smith said companies may wish to maintain high levels of cash on their balance sheets as their management teams have been shaken by the pandemic.
"We could have an event whereby the savings rate falls, which is very inflationary. But on the flipside, we could have a scenario where savings rates remain high," he added. "It is all about balancing the short-term and long-term views in this kind of environment."