DANIEL McKERNAN

At the moment, investors seem to have returned to a ‘lower for longer’ mindset, with interest rates at historically subdued levels. There is little expectation of interest rates rising in the UK or Europe and even though the Federal Reserve in the US looks set to continue with interest rate rises, these are not expected to be significant in the short-medium term. Furthermore, although global growth has improved, inflation is resolutely refusing to pick up, even in the US where early signs of improvement led to initial optimism. The reason inflation remains weak varies from country to country; for example, in the UK it could be a sign that households detect signs of future economic weakness.

However, bond prices are affected by more than just interest rates and inflation. There is also a political risk premium priced into many government bond markets. Politics will continue to play an important role as we progress through 2017 and there are of course the Brexit negotiations that will commence soon, affecting the flow of trade, capital goods and labour both from the UK and to the UK.

For fixed income investors, a world of low interest rates poses a challenge: how do investors generate the returns required from fixed income especially when volatility among other factors creates the potential for significant downside risks?

Our belief is there are still opportunities for astute stock pickers. We are seeing a number of companies that are showing improving profitability that have also reduced the debt on their balance sheets. A good example would be the banking sector. Banks have made huge strides to repair and improve their balance sheets and regulators continue to push for even stronger balance sheets to insulate the sector from a variety of downside risks. Therefore, from a corporate bond perspective, there is a much smaller risk that investors will suffer a capital loss. Clearly picking the right company to invest in is still vital as not all banks are in as strong a position. Italian banks, for example, still struggle with fragile profitability and weaker balance sheets.

Elsewhere, Emerging Market (EM) local currency debt offers some of the best yields available to fixed income investors. With current account deficits in major emerging markets far lower than a couple of years ago, and growth recovering in countries which have experienced recessions, currency risk is also lower than it has been. The growth recovery is also relatively modest and therefore unlikely to trouble central banks as they consider their inflation objectives. Indeed, the major feature of inflation outcomes across EMs has been that they have been falling rapidly in most countries that have been experiencing high inflation, allowing for rate cuts that can help to deliver capital returns for bondholders. The standout region in terms of growth is central Europe, which should outperform during this year. Furthermore, currencies in EMs are cheap and should respond positively to potentially higher interest rate expectations.

Ultimately, for investors the challenge of achieving their desired level of return in a world of low yields, while limiting downside risks, looks set to continue for some time yet. It should also be remembered that, when yields are low and uncertainty is prevalent, limiting downside risk can prove just as important as capturing upside potential. There are, however, undoubtedly opportunities in bond markets that could deliver attractive single digit returns. The key is to remain focused on diversification or look for unconstrained strategies that have the ability to access several sources of potential return rather being reliant upon a single market.

Daniel McKernan, Head of Sterling Investment Grade, Standard Life Investments