Although economic conditions are fragile, fixed income markets have been supported by central bank policies and government stimulus measures. If the environment offers opportunities it will stay challenging for investors.

Fixed income investors are typically rewarded for the risk of holding bonds that have more time to maturity in the form of term premia. This reflects the fact that the real value of the future cash flows is impacted by inflation and the relative attractiveness of these cash flows depend on future interest rates. Term premia are generally higher when there is uncertainty over future employment and inflation. But currently investors are not being rewarded for holding bonds with longer maturities, with term premia at historical lows.

Investors seeking protection from rising inflation can invest in inflation-linked bonds, known as linkers. These securities are mainly issued by sovereign governments and are indexed to inflation so that the principal and interest payments rise and fall depending on the rate of inflation.

As inflation expectations have fallen, linkers have increasingly underperformed non-inflation linked government bonds. The extent of this underperformance is a reflection of the view that significant increases in inflation are unlikely.

We think inflation expectations are too low and inflation is likely to increase moderately to a manageable level. As inflation expectations increase, this will lead to a return of term premia, reflecting the additional risk born by investors holding longer-term bonds and an increase in the relative performance of linkers.

Corporate bonds tend to offer higher yields than government bonds because they are generally riskier. There is a possibility that the companies issuing them could go bankrupt and then default on their debt payments. Liquidity is another issue that has concerned fixed income investors in recent years, with many worrying about whether they will be able to buy and sell bonds if market conditions deteriorated.

During the current crisis a lack of liquidity and spreads reached a level not seen since the Global Financial Crisis (GFC), implying a level of defaults similar to that seen during the GFC.

However, central banks have stepped in to reassure markets, and their asset purchase programmes have reduced default risk and improved liquidity conditions. The most recent corporate bond issues have been popular with investors, which suggests that credit remains attractive.

We believe European companies will continue to be supported by the European Central Bank’s policies. They include skipping dividend payments and relaxing capital requirements for the financial sector. These measures should also benefit non-financial companies by making it easier for them to obtain loans.

Central banks around the world have stepped in to support government measures to stimulate their economies in the wake of the Covid-19 lockdown. In addition to cutting interest rates, we have seen increases in asset purchasing programmes to support the efficient functioning of financial markets. This happened faster and with more scale than the response to the financial crisis.

Although we don’t expect it to happen in the short term, it is important to consider what will happen when central banks eventually scale back their support. The obvious answer is that bond yields will rise as demand falls, and volatility will increase. In Europe, government bonds issued by countries that have benefited most from the support will be most at risk, which are those on the periphery and Germany.

When central banks decide it’s the right time to begin unwinding their asset purchase programmes, they will need to communicate their intentions clearly to avoid disrupting the markets. Yield curves are likely to flatten, with shorter-term bonds underperforming as economic conditions eventually improve and interest rates begin to rise gradually.

This diverse market continues to expand, and there are 74 countries in the benchmark indices today compared with 27 in 2000. This diversification helps to reduce risk for investors, and there are a growing number of specialist funds that provide exposure to these markets.

At a time of record low bond yields across developed markets, we believe emerging market debt can provide more attractive returns than other fixed income assets over the medium and long term. Those funds that incorporate ESG factors into their investment decisions are likely to see the highest returns, and in particular by making sure high standards of governance are applied in the countries in which they are investing.

Across various measures of value, emerging market sovereign debt denominated in hard currencies looks attractive. Spreads have widened to extreme levels, which imply a cumulative default rate that we believe is far too high. Notably, the joint headwinds of weaker oil prices and a strong US dollar should fade later in the year, which will support performance.

High-yield bond spreads have widened substantially since the coronavirus pandemic took hold, as investors reallocated their portfolios from higher-risk assets to safer ones. Credit-rating agencies have also downgraded many companies, hurting all borrowers, and weaker ones in particular.

However, the vulnerabilities in the high-yield market could be partially offset by the supportive measures from governments and central banks. Although the economic outlook remains uncertain, current valuations indicate that this period could be an attractive entry point for investors into selective high-yield securities.

Notably, high yield offers an opportunity to invest with a sustainable lens. A number of funds seek to improve their investment performance by identifying issuers whose social and environmental practises are exhibiting an improving trend. They believe that an improvement in these factors will enhance credit fundamentals.

Some funds seek to accelerate the social and environmental improvement trend by engaging with their issuers to encourage positive change in line with measurable frameworks, such as the United Nations Sustainable Development Goals.