Consensus expectations for core inflation had been a 30 point increase. Headline CPI rose two percentage points to 2.9% in December, in line with expectations.

The increase was fuelled by energy prices, which accounted for over 40% of the monthly rise, while food prices also contributed.

The data release follows on from UK inflation figures for December, revealed earlier today, which revealed an unexpected drop in headline inflation to 2.5%.

See also: ‘Not out of the woods yet’: UK inflation falls by 10 basis points in December

Hetal Mehta, head of economic research at St. James’s Place, said the US inflation data would come as a relief to a wide variety of policymakers as global yields move lower.

“Core inflation surprised on the downside and there are tentative signs that inflation pressures may have stopped building after months of acceleration. But headline inflation did tick up and more evidence of inflation moderation will be necessary to get the Fed comfortable with multiple rate cuts this year.

“We don’t think these data change our view of a soft landing, with growth moderating to a trend-like pace. The Fed has the firepower to cut rates if things do start to deteriorate materially.

“Overall, the outlook is still quite muddy as so much will depend on what the Trump administration comes up with policy wise (especially tariffs and immigration).”

See also: The undervalued markets where managers are diversifying away from the US

With all eyes on the bond market in recent weeks, treasury yields have ticked lower in early trading following the release of the inflation print.

“The US Treasury market, and global rates markets, breathed a sigh of relief as the US CPI contained few surprise. In fact, the small miss on core CPI was cheered on by the market, pushing bond yields sharply lower. Headline CPI was 2.9% year-on year,  bang in line with consensus but higher than the 2.7% reading in November,” said Aegon Asset Management investment manager Colin Finlayson.

“The small miss on Core CPI at 3.2% vs 3.3% – led by an easing back in core services prices – was welcome relief to investors after a relentless sell off over the last month.  For a market living on its nerves, anything other than an upside surprise was a ‘win’.  

“After the softer inflation data in the UK this morning, this has offered a crumb of support to bond market ‘bulls’ and was a reminder that things other than fears over fiscal spending and term premia can drive Government bond markets.  For the Fed, this keeps the path in rates still to the downside and has brought forward the pricing of the next cut from December – as it was after the recent employment report – to July.”

Tina Adatia, head of fixed income, client portfolio management at Goldman Sachs Asset Management, added: “After recent red-hot data, today’s softer than expected core CPI reading should help cool fears of a reacceleration in inflation.

“While today’s release is likely insufficient to put a January rate cut back on the table, it strengthens the case that the Fed’s cutting cycle has not yet run its course. With labour market data remaining robust, however, the Fed has scope to be patient and more good inflation data will be required for the Fed to deliver further easing.”

Meanwhile, the 10-year gilt has risen to its highest level since the great financial crisis.

The spike has led to concerns over the state of public finances, particularly following chancellor Rachel Reeves’s tax-raising Budget at the end of October. However, Laith Khalaf, head of investment analysis at AJ Bell, says that placing the blame solely on the chancellor is “probably wide of the mark”.

“Reeves’ maiden Budget was marginally inflationary, and did increase overall government borrowing, but since the beginning of October the US and UK 10-year bond yields have tracked upwards almost hand in hand.

“Those who think the current bout of bond market jitters is down to policies announced in the Budget need to explain why there has been such correlation in the upward march of bond yields both here and in the US.”

See also: ARC: Inflation leaves private portfolios 12% below 2021 levels

Fidelity International portfolio manager Mike Riddell agrees that the upward trend is mainly a global fixed income story.

UK gilt yields have moved broadly in line with US Treasuries over the last few months, while Riddell also points out that there has been a similar sized move in long dated German government bonds in the last month.

“That’s not to say that the UK has been immune to pressure,” he says. “Although there’s not any sign of a UK crisis yet, a worrying development in recent days is that gilt yields have risen a little more than in other markets, at a time when sterling has sharply weakened. 

“Normally currencies are driven by interest rate differentials, where higher gilt yields relative to other countries would be expected to push the pound stronger. The combination of a weaker pound and higher relative gilt yields has eerie echoes of August-September 2022, and if this continues, could potentially be evidence of a buyer’s strike or capital flight. 

“What’s been interesting about the global bond market moves of the past few weeks is that this is an unusual ‘bear steepening’ move, where longer dated bond yields have risen by more than short-dated yields. These moves are indicative of fixed income investors becoming increasingly concerned about fiscal largesse, and all the government bond supply that accompanies it. 

“It’s not about inflation concerns, where the market’s medium term inflation expectations are little changed since the beginning of November. Investors are instead demanding a higher risk premia or ‘term premia’ to compensate them for owning longer dated government bonds.”

Buying opportunity?

Among the implications of the gilt yield moves, refinancing debt has become more expensive.

“If this selloff continues,” Riddell adds, “it’s going to push deficits wider over the long, which then risks a doom loop since deficits need to be funded by ever more sovereign issuance. 

“But it’s also bad news for corporate issuers, or for example anyone who wants a fixed rate mortgage – a jump higher in the risk-free rate is a tightening in financial conditions, which will dent global economic growth. So if sovereign borrowing costs continue to surge higher, then risk assets such could start to come under substantial pressure.

“But the positive news it that the potential return from owning government bonds has just got a lot higher too. If you buy a 30-year UK government bond today and hold to maturity, then assuming no default of course, the total return over the life of the bond is almost 400%.” 

Richard Carter, head of fixed interest at Quilter Cheviot, says that gilt yields present an attractive opportunity for long-term investors.

“Despite this turbulence, gilt yields still present an attractive opportunity for long-term investors. Currently, they are well above expected inflation levels, making them a viable option for those looking to secure returns in a sluggish economy that might prompt further rate cuts by the Bank of England.

“For investors with a lower risk appetite, short-dated gilts still offer a promising avenue and are less sensitive to market fluctuations.”

Investors are on edge, grappling with uncertainty on multiple fronts as the US election fast approaches. With the outcome seemingly hanging in the balance, the potential impositions of blanket tariffs from a Trump presidency on all trade is concerning many. Such a move could spell trouble for the global economy, bringing potential implications for long-term geopolitical stability and fiscal discipline.

One significant tail risk we are monitoring is the impact of the US fiscal balance sheet. At around 4%, treasury yields are not overly concerning, but they reflect some uncertainty. While we do not anticipate a UK-like event in the US — a major bond sell-off akin to the Truss mini-budget moment — continued volatility in the bond markets leading up to and potentially beyond the election is likely.

While it is notoriously difficult to predict election results, and therefore subsequent policy of future administrations, the possibility of a Trump presidency focused on additional fiscal expansion and deregulation could push inflation higher, raising the yield of long maturity bonds as investors price greater long-run uncertainty in US bond markets. This ripple effect could inevitably be felt across the broader global bond market, as the US remains the benchmark for global fixed income.

See also: Morningstar: What does the US election mean for investing in China?

The potential imposition of blanket tariffs by Trump is especially concerning. While this could give a short-term inflationary boost to industries such as traditional energy, financials and defence, it could be disastrous for global growth over the long term. Take tariffs on China as an example. These have already led to a decline in US-China trade over the past few years and increased trade deficits with other countries. This rebalancing effect of blanket tariffs on US trade partners would complicate global trade dynamics.

The US economy has been sending mixed signals in recent months. The challenge lies in the core components of inflation, which seem inconsistent with the cut of over 1% the market expects from the Federal Reserve in the next 12 months. This creates a dilemma for the Fed, which must balance lowering inflation with a strong but potentially weakening labour market.

Historically, equity markets have shown more volatility during close and contentious elections. Given polling data indicates a tight race hinging on a few swing states, such uncertainty could spur heightened market volatility as investors react to polling trends and shifting political dynamics. While markets tend to calm after an election, investors should not assume smooth sailing in the immediate aftermath.

Policy changes, particularly those related to fiscal spending, taxation and regulation, could significantly impact sectors such as technology, energy and healthcare. leading to heightened market volatility as investors react to polling trends and shifting political dynamics.

Despite the noise, investors should remain steadfast: focusing on long-term fundamentals and preparing rather than predicting. Forecasting market responses to elections or economic data is fraught with risk. But discipline is needed — diversifying portfolios, managing risk and avoiding overreactions to short-term market moves.

While the election presents both short-term risks and opportunities, in line with past elections it is unlikely to have an impact on the medium-term expected returns of asset classes, but will stir potential short-term challenges.

While global bond yield curves may steepen globally pushing up longer term interest expectations, bonds remain an attractive asset class to hold with fears remaining around economic growth. We may also see volatility in equity markets as traders react to each other post-election, focus should be on the medium-to-long-term fundamentals — such as earnings and the discount rate — that will drive equity returns and ultimately client outcomes.

See also: Weekly Outlook: US election, UK and US interest rate decisions

Currency markets are also an area that may see volatility, especially if election results are delayed in swing states. However, we see little immediate threat to the US dollar’s status as the world’s reserve currency. Despite speculation, neither the euro nor renminbi are poised to replace the dollar.

Investors therefore should assess any risks within their portfolio and ensure they are resilient to adverse outcomes, while remaining flexible to seize opportunities that may arise during periods of extreme market stress.

Whether we face a Trump 2.0 presidency with potentially higher inflation or a Harris-led government which would likely be more of a continuation of the current administration, it is important to ensure that portfolios are diversified and robust.

By maintaining a disciplined, medium-term view and avoiding being swayed by the noise, investors can navigate the election with confidence, focusing on fundamentals rather than short-term volatility.

This article was first seen in our sister publication, PA Adviser

The data comes as bond yields hit their highest level since the financial crisis. However, in the past year, the market has shifted rapidly. While the Bloomberg Global Aggregate index fell 3.6% from the beginning of the year to its trough in May, it now has a year-to-date return of 0.82%.

Although gilt yields spiked following the Autumn Budget, they have now largely settled to levels from before the announcement. In 2024, the Bank of England made two rate cuts to reach an interest rate of 4.75%.

See also: UK inflation jumps to 2.3% for October

In the US, treasury yields also lowered as Scott Bessent was chosen as US Treasury Secretary. While the Federal Reserve has cut interest rates twice this year for a total of 75 basis points, worries of inflation under a Trump presidency have caused uncertainty on how cuts will continue in 2025.

In its 2025 outlook, Vanguard priced in a rate of 4% by the year’s end, and Goldman Sachs expects a terminal interest rate of 3.25% to 2.5% for the Trump administration.

Jeremy Leach, chief executive officer of Managing Partners Group, said: “Fixed income funds have seen increasing inflows recently and this new research shows that institutional investors and wealth managers are set to significantly increase allocations over the next 18 months.

“Particularly as we enter a period of high volatility, the benefits of diversification and a regular income means fixed income is an increasingly popular choice for institutional investors and wealth managers.”

Most investors believe their allocation to bonds will rise by 10% to 15% in the next 18 months, while near a quarter see allocations rising beyond this share. Just 10% of investors believe allocation will increase by 10% or less. Currently, just 17% of investors say they are overweight fixed income.

See also: Will bond yields stay higher for longer?

The managing director tells Portfolio Adviser that, despite interest rates across the developed world already beginning to fall as inflation tempers, fixed income funds will remain popular among investors for their higher returns and attractive yields relative to cash.

According to the latest flow data from the Investment Association, fixed income funds attracted £1.8bn throughout the month of August, pulling overall sales of investment funds to £804m despite losses across equity, money markets, mixed asset and property.

“At the moment, our lowest-risk portfolio has a 15% allocation to cash and money-market instruments. Is this likely to be as high next year, or will this weighting come down and get partially moved into fixed interest? Given the yields on offer, I suspect it will be the latter,” Hughes says.

“This is a trend that we are already seeing now – albeit money market yields are still quite appealing in the short run – but I expect this to continue over the medium term, as this will start fading at the end of the year and early next year.

“I would absolutely expect money to flow out of money market funds and into the fixed interest market.”

See also: What does the gilt yield spike mean for UK bond prospects?

The question remains, according to the managing director, as to which types of fixed income propositions investors will favour. For instance, investors could move “one step up the ladder” and buy into short-dated corporate bonds, or they could “eke out a bit of extra return” by taking on more duration risk and moving into standard markets.

“I think it’ll probably be a bit of a mix of the two,” he reasons. “People will remember being burnt while holding bond funds only a couple of years ago, when they saw drawdowns of 15-20% in what is supposed to be a ‘safe’ asset class. So, I suspect people will be nervous about taking lots of duration risk at the moment, even if it might be the right thing to do.”

Portfolio rebalancing

Hughes has been positive on fixed income “all year”. In January 2024, when the firm was updating its portfolios with the team’s overarching views, it added “quite a bit” to the asset class on the expectation of interest rate cuts throughout the year. “We also thought the yields on cash were going to fall as well – which is two sides of the same coin,” he explains.

“So, we started moving out of cash and adding duration in January; we were doing this in a couple of places. We were adding to UK gilts and UK corporates. We thought that UK investment-grade corporates looked like the sweet spot to us – given the yield pick-up we were getting over cash and government bonds, as well as an incredibly low default rate.

“We were seeing an average 100 basis-point return over cash, maybe more at various points.”

See also: Three ways asset allocators are buying bond funds

This was during the first half of 2024, and Hughes admitted it “didn’t really work like that” given stickier-than-expected inflation data, and central banks “kicking rate cuts further down the road”.  

“Bonds actually underperformed cash during the first half of the year. But in the second half, we saw inflation data start to fall backwards quite sharply, with some employment data from around the world coming in slightly weaker. Then, we saw rate cuts come through in the eurozone, the UK and the US, which has clearly fed through to bond yields.

“This position started to work quite nicely for us in the second half [of the year].”

UK corporates and US treasuries

Hughes has a preference for UK investment-grade corporates because yields are higher than in the likes of the US or Europe. AJ Bell also reaps the benefit of them being sterling-denominated as opposed to receiving sterling-hedged yields.

“Compared to the likes of European investment-grade bonds, we are getting about a 1% yield pick-up on that,” he explains. “However, in our international bond bucket – our non-hedged bucket – we overrode using global government bonds as a core asset class and instead bought US Treasuries.

“The reason is that the global government bond index has some US bonds and some UK bonds, but it also has a lot of European and Japanese government bonds.

“Across both of these regions, the yields have been artificially supressed by government and central bank action. At the start of the year, you could get a 1% yield pick-up by owning dollar bonds rather than global government bonds.”

The managing director says there is the “added attraction” of the US dollar serving as a “safe haven hedge, if things get ugly out there”.

“Now, sterling has strengthened against the dollar, but it really matters. We were getting paid a higher yield, while benefitting from having a hedge in the portfolio if things got difficult. For us, it looked like an attractive trade and it has worked out exactly like that

“US treasuries have outperformed global government bonds this year.  I think this is a subtlety that quite a few people might have missed, that they benefit from the yield pickup and keep their edge without getting exposure to the likes of Japan and Europe.”

High-yield headwinds

One area of fixed income AJ Bell has been reducing its exposure to is high-yield fixed income. At the start of the year, the team had a 10-12% position in the asset class, but this has since been halved due to tight spreads.

See also: Square Mile: Are falling US interest rates the panacea for bond funds?

“We didn’t think we were being paid suitably for the risk we were taking,” Hughes says. “We have been wrong on that, because spreads have become even tighter. High yield has actually performed very well this year, largely on the back of strong equity markets, too. We had some exposure but not as much as we did have – that cost us a little bit.

“However, we’re very comfortable with the fact we took some of that risk out of the portfolios, because the risk-return trade-off did look weak at the end of August. On the day that the Japanese stockmarket suffered a big correction, high-yields spreads blew out by 1% in a day.

“This just shows what can happen when you’re trading at very, very tight spreads. As soon as any kind of shock or uncertainty rears its head, the risk of drawdown can be high.

“Therefore, we are perfectly happy parking that capital in investment-grade bonds – obviously while being paid a lower coupon, but having a much lower risk at the same time.”

Increased levels of borrowing has meant UK 10-year government bond yields have risen by nine basis points overnight to time of writing (11.45 am, 31 October) as markets digested the prospects of further gilt issuance and an uptick in borrowing to bolster infrastructure spending.

Yields on 10-year gilts have risen by more than 50 basis points since mid-September, during which time Chancellor Reeves announced a technical change to how debt is measured – redefining it as defined as “public sector net financial liabilities” – in order to allow additional government borrowing.

See also: Autumn Budget 2024: Ten key takeaways

Chris Arcari, head of capital markets at Hymans Robertson, pointed out that gilt yields initially fell during the first part of the Budget, but that they rose again as soon as during the opposition’s response.

“With the government set to invest an additional £100bn over the next five years as a result of the tweak, we believe they are showing welcome restraint against the £50bn per annum of headroom the changes create,” he pointed out.

 “The OBR has raised near-term growth forecasts and, crucially, as a result of increases to investment, has raised the long-term potential growth forecast for the UK.”

Arcari added: “The market will need to recalibrate for materially higher near-term government expenditure and potential rise in business’ labour costs, but we believe the systemic risks to the market are low.”

Garry White, chief investment commentator at Charles Stanley, argued that the rise in gilt yields can also be attributed to uncertainty in the US, with UK gilts and US treasuries continuing to move in lockstep.

See also: Autumn Budget 2024: Reeves restructures debt, with borrowing spending focused on investment

“The Budget has sparked volatility in gilt yields (and will continue to do so), but gilts are very heavily influenced by global government bond moves, and therefore economic data from the US and Europe,” he explained.

“On the day the Budget was delivered, there was a sharp sell-off in the hours following the statement as markets digested the extent of fiscal easing announced by the Chancellor. The Office for Budget Responsibility (OBR) revised the bank and gilt rate upwards by 25 basis points over the forecast period, reflecting expectations of higher rates for longer.

“Furthermore, the anticipated additional £20bn of gilts issuance was skewed more to the long end of the yield curve than markets were anticipating, promoting a greater rise in longer-dated yields, and a steepening of the yield curve.”

White added that rise in the minimum wage could be inflationary, although he pointed out the futures market is still pricing in another 25-basis-point cut from the Bank of England at its November meeting, “so nothing has changed on this front either”. 

“Movements in gilts are very heavily influenced by global treasury moves, particularly economic data from the US. Indeed, a lot of recent moves in bond markets can be attributed to uncertainty across the Atlantic ahead of the looming presidential election.”

Russ Mould, investment director at AJ Bell, said an increase in UK government borrowing could mean “interest rates stay higher for longer”, which has been reflected by lacklustre returns from the housebuilders and retailers since the London Stock Exchange opened this morning.

“The idea of rates staying higher for longer was also relevant to the US market after GDP figures pointed to a robust economy. That might encourage the Fed to be less aggressive with rate cuts,” he warned.

However, Mould believes this could spell more of an issue for equities rather than fixed income.

“Many investors were hoping big rate cuts would create another tailwind for equities, particularly tech stocks, so add in a slight setback on this front with a negative response to Meta and Microsoft’s latest figures and you’ve got the potential for a gloomy day [across stockmarkets].”

The EdenTree Global Select Government Bond fund will target 80% exposure to government-focused green, social, sustainable, or impact bonds. David Katimbo-Mugwanya, head of fixed income, will manage the fund and will use EdenTree’s proprietary Oppressive Regime screen to remove countries that are identified as having an opressive regime. The screening process uses assessments from Freedom House, Transparency International, and the World Economic Forum to score countries on a range of criteria.

The fund will aim to offer regular income, payable quarterly. It joins the Edentree Responsible & Sustainable Short Dated, the Responsible & Sustainable Sterling Bond and the Global Impact Bond strategies in Edentree’s range of fixed income funds.

See also: Fidelity launches duo of sustainable bond ETFs

“In its latest assessment of development investment around the world, the United Nations (UN) estimates that $4.2trn per annum is required to close the development financing gap, up from $2.5trn before the Covid-19 pandemic. Urgent steps are needed to address global sustainable development funding requirements, and governments have a unique ability to mobilise capital at scale through vast debt issuance programmes, placing them in a prime position to fund projects that tackle these societal challenges,” Katimbo-Mugwanya said.

“Sovereign ESG-labelled debt issuance is continuing at an unprecedented pace, with government and or related issuance making up just over half of the outstanding global universe of use-of-proceeds green, social and sustainable debt. In a market environment that offers considerably higher bond yields compared to the last decade, the risk-return profile of government debt from an asset allocation perspective has markedly improved. As such, we believe this new fund is ideally placed to leverage these market dynamics in the best interests of clients seeking to credibly enhance sustainable fixed income offerings when allocating to government debt.”

See also: Alliance Witan makes manager change as portfolio transition completes

James Tomlinson, head of wholesale distribution, added: “The EdenTree Global Select Government Bond fund has been developed in close partnership with an existing client to meet a specific strategic requirement for a sustainable government bond solution.

“Fixed income is playing an increasingly important role for investors seeking to link financial goals with the desire to address pressing societal needs and environmental concerns. While equities have traditionally dominated the options available for responsible investors, fixed income now provides innovative sustainable investment products with varying risk profiles, degrees of impact and competitive rates of return. With this in mind, we are delighted to further enhance our fixed income offering, providing our clients with greater flexibility and increased choice when it comes to meeting their investment and sustainability goals.”

The circumstances of 2022 were extreme. Interest rates had been at unprecedented lows, and then rose incredibly fast. At sub-zero yields, bond markets had become vulnerable to a sophisticated version of pass the parcel, where instead of a present, the person left holding it would be left with a portfolio of underperforming debt.

To be clear, fixed income markets do not have the same vulnerabilities today. However, some concerns have started to emerge on valuations. There are question marks over whether government bond markets are pricing in too high a level of interest rate rises, and whether corporate bond spreads leave any margin for error.

See also: Small caps: Is it time for some UK cheer?

Looking at corporate bonds, Damir Bettini, fixed income portfolio manager at Capital Group, agreed that there are risks.

He said: “There is an ongoing vigorous debate in the market as to whether global corporate bonds are expensive or offer good value. Those that are making the case that the asset class is expensive points out that credit spreads are at multi-decade tight levels.”

He admits that current spread levels suggest a negligible chance of recession, adding: “If we get a reasonable-sized recession – something that is consumer-led, and impacts asset quality, there could be 100bps of spread widening.”

However, he said the greatest risks come in a stagflation scenario, where central banks need to raise rates because inflation takes off and there’s no growth. He believes this scenario looks unlikely and that’s why markets are generally taking a positive view. For him, the global economy appears resilient, with inflation falling and plenty of scope for central banks to cut rates even without a recession.

Bettini added: “Even if corporate bonds do look expensive at an aggregate level, it is a broad, deep asset class. We see a fair amount of dispersion across regions and across industries. The US is very expensive, while Europe has lots of interesting investment opportunities. The UK is currently sitting between US and Europe and we’re also finding good opportunities in Asia.”

Perhaps, most importantly, corporate bonds still offer an attractive yield. Dillon Lancaster, manager on the TwentyFour Dynamic Bond fund, said: “When yields are attractive and correlations are correct – ie a negative correlation between corporate and government bonds – fixed income markets usually behave very well. Our Dynamic Bond fund has a yield of 6.7%, and the average rating for our holdings is BBB+.” This combination of high yield and low risk is likely to keep investors interested in the near-term.

Government bonds

Government bonds are facing different pressures, but the biggest problems are appearing in the US market.

David Roberts, head of fixed income at Nedgroup Investments, said: “At the time of the recent US rate cut US 10-year Treasury bonds paid a yield of 3.65%. Thanks in part to stronger than forecast data, stronger perhaps than the Fed had anticipated, that yield actually increased to more than 4% by 6 October. Yields had already been rising for a couple of weeks prior to [Jerome] Powell cutting rates – markets priced too many cuts, were too worried about the jobs market and started to fret about post US election fiscal policy.”

Lancaster said post-election policy is a worry, with neither side appearing to care very much about whether the deficit keeps expanding.

See also: Investment trusts: Retail investor take up of private equity trusts remains low

He added: “The main thing for the market is not who is going to win, but the make-up of the Senate and House of Representatives. The market will breathe a sigh of relief if there is a split government. The US is the founding father of checks and balances in its system. If there are competing interests from Congress and the President, nothing gets done. The market wants gridlock because that might help bring the deficit under control.”

His view is that longer-dated US government bonds could be vulnerable to a sell-off if there is a Republican sweep. Trump’s tariffs could be inflationary and there would be worries over any interference with the independence of the Federal Reserve. In a split government, long-dated bond yields could fall, and under Harris, they would probably stay unchanged.

Mark Dowding, BlueBay CIO, RBC BlueBay Asset Management, is bearish on 30-year yields. He said: “Looser fiscal policy points to a need for term premia to increase on a structural basis, and we think fair value for the long end of the curve is likely to sit closer to 5%.” It is currently 4.4%.

Lancaster said there is an Armageddon scenario, where the US experiences a Liz Truss style meltdown in its bond market. It is worth noting that a significant chunk of US treasuries are bought by ‘unfriendly’ nations, such as China. However, he sees this extreme development as a remote possibility, and believes there is always likely to be a buyer for US treasuries.

Government bond markets elsewhere do not have the same political risks, nor do they have the same expectations on rate cuts built in, though an Armageddon scenario would sink all boats. Non-US governments cannot afford to take such a devil-may-care approach to their deficits. This is particularly notable in the UK, when government bond yields have proved sensitive to merest hint that Chancellor Reeves may change the debt calculations to support investment.

The overall picture is that bond markets are not cheap in aggregate, but there is considerable nuance beneath the surface, with different durations, regions and sectors offering different value. On core metrics such as income and diversification, fixed income still earns its place, but there are pitfalls, and the environment argues for selectivity.

See also: Are the negative flows from UK equity funds justified?

This article originally appeared in our sister publication, PA Adviser

The strong performance from bonds pulled overall sales of investment funds to £804m for the month, despite losses across equity, money markets, mixed asset and property. It marks the third month in a row that sales have stayed net positive.

Equity funds experienced the largest outflows for August, losing £408m. It marks the second month of outflows for the asset class, which dropped £50m in July after a June upswing of £1.2bn.

See also: Fairview’s Yearsley: China becomes ‘story of September’

Bonds, however, paint something of the opposite picture over the last three months, after moving largely in tandem with equity until June this year. August is the bond sector’s second month of inflows, after a £518m increase for July, yet it lost £1.2bn in the month of June. Government bonds were the largest draw for the asset class this month, with £837bn in inflows.

Miranda Seath, director of market insight at the Investment Association, said: “The Fed’s more aggressive interest rate cut of 50 basis points in September represents a significant milestone, as the Fed seeks to steer the US economy to a soft economic landing and markets responded positively. 

“We have moved past the peak of the rate cycle in the UK and the US and the outlook for equity markets is improving but investors remain cautious, continuing to opt for bonds over equities. Recent short-lived market volatility in the US at the end of July was partly fuelled by poorer than expected jobs growth. The path to a soft landing could be bumpy and this could bring new pockets of market volatility. And whilst UK investor confidence is improving investors are also waiting to see what the Autumn Budget holds. Post Budget we may see further adjustment to asset allocation.”

August did not show investor confidence in the home market as of yet, as UK All Companies experienced £629m in losses, the largest across all sectors. UK funds by region also dropped £829m. Just North America and global funds attracted investors overall for August, with regional inflows of £527m and £308m, respectively.

See also: ISS: Model portfolio sales quiet in first half of 2024

Including investments in money market funds – which also benefited from higher savings rates – the number increases to 247% over the period.

Of all those investments, gilts were the most popular, with holdings rising by 2,019% over the past two years.

They yield upwards of 4%, which is less than the 5.5% average on offer from investment-grade bonds, but their backing by the UK government gives them more security. Gilts have never defaulted on debt, meaning investors have greater peace of mind holding them.

See also: Lipper: Bonds attract €24.5bn amid rate cut anticipation

They also have the added benefits of being free from capital gains tax. Sam Benstead, fixed income lead at II, said: “Because a large part of the total yield from low coupon gilts issued when interest rates were near zero comes from the capital uplift when the bonds mature, they are a useful tool to pay less tax on investments held outside of tax-efficient wrappers, like SIPPs or ISAs.”

Although fixed income investments have risen substantially over the past two years, Benstead added that it might be a good time to increase exposure further.

With central banks likely to cut interest rates from their current highs, bond prices could rise as the fixed income they offer becomes more valuable, according to Benstead.

“Bonds are also better portfolio diversifiers today than they were before interest rates began to rise,” he said. “In the event of an economic shock, central banks now have capacity to cut interest rates to stimulate the economy, which should be good news for bond prices.”

The five most popular bond funds that investors are currently holding are iShares Core UK Gilts Ucits ETF, Vanguard Global Bond Index, Royal London Sterling Extra Yield, Invesco Monthly Income Plus and iShares Core £ Corp Bond UCITS ETF.

The conventional UK investor has typically opted to allocate their exposure to EMD into blended strategies, which invest in a combination of the three subcategories. By investing with an active EMD manager within the blended space, investors try to benefit from the expertise of investment managers who tactically move portfolio exposures across the different subcategories as market conditions evolve, optimising the risk and return characteristics of the portfolios.

Nevertheless, EMD funds have not historically been favoured by the conventional UK investor, who prefers to dedicate their fixed- income allocation to more traditional and core strategies, such as government bonds and investment grade corporate bonds. The combination of political risk, default risk, liquidity risk and in some cases also currency risk, makes EMD a volatile asset class, and therefore outside the consideration of the defensive characteristics typically required for fixed income allocations.

See also: BNP Paribas names head of emerging market debt

The asset class remains therefore a specialist sector, home to more sophisticated clients such as institutional investors and family offices. The demand for emerging markets has slowed during the past two years, with significant outflows in the retail market.

The asset managers have also reduced the number of launches of new funds in the sector for the UK retail market over the same period, with the number of EMD funds across the Investment Association sectors increasing by only two funds. It stands at a total of 121, as of the end of March 2024.

Read Eduardo Sánchez’s funds to watch by assets under management, three-year performance and newcomers in May’s Portfolio Adviser magazine

The JPMorgan Liquidity Funds – EUR Government CNAV fund is a short-term public debt constant net asset value (CNAV) money market fund.

The strategy will invest in short-term EUR denominated government bonds, treasury bills, and other money market instruments, as well as reverse repurchase agreements.

See also: What does the future hold for money markets?

Jim Fuell, head of global liquidity sales, international at JPMAM, said: “With interest rates in Europe now firmly in positive territory after a decade of negative levels, we’ve observed growing demand from investors for a money market fund with exposure to short-term government rather than bank-issued short-term debt.”

The strategy will be managed by managed by Joe McConnell and Ian Crossman, and will offer share classes for retail and institutional investors.

JP Morgan’s Fuell added that the fund might appeal to investors seeking an alternative to cash deposits for their medium-term or temporary cash investments, including seasonal operating cash or the liquidity components of investment portfolios.