Short duration portfolios are key

Global government bonds start 2004 as one of the least favoured asset classes worldwide. Surveys of bond fund managers start the year showing that the predominant position is to hold short duration portfolios - for instance, most fund managers are expecting yields to rise. It is easy to see why. Nominal yields are low, the global economy is recovering fast, there is speculation over rising interest rates and public sector deficits are rising.

For the first time in several years there is an air of optimism surrounding higher beta asset classes (such as equity markets) as the repercussions of the technology bubble bursting, corporate scandals, terrorism and conflict in the Middle East start to fade and the benefits of the massive monetary and fiscal easing that has taken place worldwide finally come to fruition.

This massive easing of policy is expected to lead to robust economic growth and eventually to higher interest rates in the face of rising inflation. In such a scenario, bond yields would have to rise and returns on the asset class would be low.

But is the outlook for government bond markets really that bleak? To answer this, firstly it is worth reminding ourselves what a fixed income instrument is and how government bonds are valued. Government bonds with fixed coupons are essentially a guaranteed stream of fixed cash flows payable over a set period at a set interest rate followed by a final redemption payment payable on maturity

The value of a fixed nominal stream of cashflows to an investor today depends crucially on two main factors. Firstly, the risk-free rate of interest, like the rate that the investor could place cash on deposit for negligible risk and have the facility to take it away tomorrow. In the UK, this is the level of base rates. So if base rates are at 5% and yields on bonds with 10 years to maturity are around 3%, an investor is unlikely to be attracted into buying a bond unless they have the opinion that base rates will fall quite rapidly to very low levels.

Looking at it the other way, if base rates are at 3% and bond yields are at 5% investors may feel happier owning bonds, knowing that although base rates might rise they have some way to go before the yield equalises.

The second factor to assess is the anticipated rate of inflation over the lifetime of the bond. It is inflation that erodes the value of a fixed nominal payment. We are all aware that spending £5 today will not buy you as much as it did 20 years ago. Higher inflation leads to the value of nominal payments to fall and vice versa, so it is of no surprise that as inflation rises fixed income markets generally perform poorly.

So the near-term outlook for the government bond markets will depend on what happens to these two factors during 2004. Take interest rates first. In the US. the federal funds rate target is currently 1%. The last statement from the FOMC suggested that this level of policy accommodation will be 'maintained for a considerable period'. In Japan, where interest rates for cash deposits are 0%, the latest policy move is to inject more liquidity into the economy via the banking system. This act shows that policy continues to be expansionary rather than contractionary.

In Europe, where the economic recovery has been slow and unspectacular to date, there is concern that the strength of the euro may curtail growth. As a result, speculation has been growing that the ECB may have to consider cutting rates to maintain economic growth.

So it would appear that none of the major central banks are at this stage considering monetary tightening, despite some encouraging economic data showing that global recovery is developing well. This is because there remains one major concern, that of deflation.

Inflation around the world is very low. In the US, the core annual rate of inflation is barely over 1.0%, in Japan it is close to zero and has been negative for a number of years - with disastrous consequences. In Europe, the core annual rate of inflation stands at 1.6%. Even in the UK, where the monetary policy committee have reversed their precautionary rate cut of earlier in the year, annual inflation stands at just 1.3 %.

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