With bond yields soaring, should investors take flight?

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Gareth Isaac, Fixed Income, fund manager  at Schroders takes a look at the recent bond market volatility and its implications for investors over the longer term.

Yields are climbing fast, but were dangerously low

The steep bond market sell-off since April has made a number of investors nervous, but this weakness should be viewed in the context of an overextended rally.  The most vertiginous rises in yields have been in Europe, where bond yields became detached from reality.

The yield on a 10-year German government bond had fallen below 10 basis points (0.10%) in mid-April, and the yield on a 30-year Italian government bond was below 2%. A rebound – particularly for longer dated bonds – seemed inevitable, although the speed of it has been a little surprising.

European fixed income has been acting as an anchor for other bond markets and now that yields are rising, the same has begun to happen elsewhere.  However, while the move in yields has been rapid, valuations have only moved back to ‘expensive’ from ‘very expensive’.

Bonds remain supported by a challenging income environment

In our view, the medium-term outlook for fixed income still looks strong. The deposit rate at the European Central Bank (ECB) is still negative, at -0.20%, and the structural demand for income by European investors should keep yields from rising too far. And let’s not forget that the ECB will continue its bond buying programme, at a rate of €60bn-a-month, until at least next September. In our view, we are unlikely to see headline interest rates rise in Europe for possibly years to come.

Regarding the medium-term outlook for the economy, we see the improvement in recent months as a cyclical recovery. There are still significant structural headwinds to the region that could return to the forefront at a later stage. Whether the positive momentum can be maintained in an environment of higher bond yields remains to be seen.

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