Bond markets have sold off heavily in recent weeks as investors digested the impact of increased inflation expectations but should this sound a warning for those with exposure to fixed income assets?
Performance of bond sectors over 2021 so far
Source: FE Analytics
Recently high bond prices and low yields on Treasury bonds have been highly accommodative to equities, especially during the past year.
But in a period of strong economic growth – which many are pricing into markets now for the ‘post-Covid’ stage – this is typically a bad market for bonds and more supportive to value style equities versus growth.
Performance of growth versus value indices year-to-date
Source: FE Analytics
FundCalibre managing director Darius McDermott (pictured) said expectations of increasing inflation have been growing despite interest rates currently showing no signs of rising for at least the next 12 months.
“This has led to losses in bonds and bonds funds over the last month, but especially in government bonds,” he said. 
McDermott said investors need to decide is whether or not they agree that higher inflation is going to happen before adjusting their portfolios.
“One’s next move is really base on inflation views. Camp A is this is short-term inflation based on the re-opening trade and the increases in energy prices from a year ago, while Camp B is this is the start of more endemic inflation,” he said.
“If it is Camp B then expect bonds to continue to underperform.”
One management team that doesn’t think inflation is going to be a cause for concern is EF 8AM Focussed’s Tom McGrath and Andrew Merricks.
Discussing their outlook for markets McGarth highlighted the “perceived threat of inflation” as a potential risk to watch out for. But the key term here is “perceived threat”, he added.
“When we put this presentation together, I had started to flag that the one of the biggest things to watch out for this year was the perceived threat of inflation and the likelihood that bond yields would rise,” McGarth said.
“And I thought equity markets will be able to digest a real, gradual drift up in the 10-year Treasury yields, which were below 1 per cent. And I thought, over the course of this year, if we drifted up slowly to 2 per cent, then equity markets could digest that and it wouldn't cause too much problem.
“What I did flag was that if they move fast, and the rate of change was too quick, and that could have unnerved investors. And the fear of inflation could become central in a lot of investors’ minds. And that's exactly what's happened.
“And that's what's caused this recent wobble in the markets, which has manifested greater in growth stocks.”
Merricks (pictured) added to this, stating that the concerns about inflation rising have been ongoing for many years but it still hasn’t materialised. Talking about the UK specifically and he said that with the government’s furlough scheme ending soon this is likely to add to the unemployment rate and see wages stagnate. 
“Forgive me for being a little bit sceptical about the spectre inflation now haunting the markets because where is it coming from? Why is it coming? Why are we so worried about it and what's different about it?” Merricks said.
Adrian Lowcock, head of personal investing at Willis Owen, seconded that idea that investors have become fixated on the vaccine rollout and this has caused a rapid shift in their attentions towards the Covid-19 recovery.
He said: “The change in sentiment has been fast and arguably investors have now become equally fixated on a strong recovery and higher inflation, leading to expectations that interest rates will rise sooner and more quickly than expected.
“The US Fed is not likely to stop injecting liquidity into the system and will want to avoid a repeat of the 2013 taper tantrum, but there is a question of does the US economy need [more] stimulus and will this cause inflation?”
On US fiscal stimulus Lowcock said that this was “unlikely to be abandoned” and given the high levels of debt he said that “some inflation will be welcomed”.
Indeed, the US House of Representatives just passed president Joe Biden’s $1.9trn coronavirus aid package, the third major stimulus package of the pandemic. It will now be voted on in Congress.
Looking at what this means for investors, Lowcock said it is important for them to ensure that their bond exposure is “flexible” and considers the wider market outlook.
“Given economists and central banks find it hard to accurately forecast both economic growth and inflation it is important to make sure your bond exposure is flexible and takes into consideration the wider economic landscape as these clearly have an impact on investment returns,” he said.
“In addition with bond yields so low, particularly government debt, it is important to remember that it is not just the asset class that determines risk but the price you pay for it and low interest rates makes government bonds riskier.”
On where investors could seek out bond market exposure Ben Yearsley, co-founder and director of Fairview Investing, highlighted emerging markets as an option.
He said: “I think investors need to ensure they understand the risk of bond markets. It’s largely been a one-way trade for 30 years with the odd tantrum, but surely that can’t continue with yields where they are today?
“Government bonds acted brilliantly as a diversifier from equities this time last year, and with yields rising recently they could do the same again. However it is difficult to look at these on a five year basis and say the return profile looks good.
“One area I do like the look of is emerging market equities. I’m a fan of emerging markets for long term equity investors and with increasing economic prosperity my same thinking runs through to emerging market bonds, especially if we enter a period of US dollar weakness.
“The simple answer to your question is add emerging market bonds to add diversity on a long-term view.”