Demand for government bonds has jumped during the coronavirus pandemic, so much so that people are now paying governments in some countries to hold their money, with yields below zero in Germany, France and Switzerland while remaining well below 1 per cent in Australia.

Looking ahead, bond prices locally will be supported by the Reserve Bank of Australia's quantitative easing program over the next year or two. However, any sign that inflation is on the rise due to the huge surge in government spending could present a risk to bond prices.

Tim Wong, a manager research director at Morningstar, says the RBA’s QE program will see the central bank buying back government bonds in order to inject money into the economy to expand economic activity.

"Through quantitative easing, the Reserve Bank is trying to keep bond yields lower further out the yield curve, which provides support for government bond prices and fixed interest securities more generally," says Wong.

"In credit markets, we have seen that spreads have contracted a little from where they were in March, though they're still wider than they were before the coronavirus pandemic. You can certainly say that the market has priced in the greater risk of defaults if companies struggle to make debt repayments as the economy contracts," says Wong.

The yield spread is a key metric for measuring the relative values bonds. A wider spread usually indicates higher risk.

Stephen Miller, head of fixed interest at fund manager GSFM, sees ongoing support for government bond prices over the next year or two.

"A big near-term risk is deflation—one only has to look at the recent developments in the oil market to understand the deflationary forces unleashed by the Covid-19 crisis. That also anchors government bond yields," he says.

RBA Governor Philip Lowe recently suggested Australia's cash rate would stay at 25 basis points until there is "sustainable progress" toward full employment and the return of inflation.

"To me that attainment of those goals is probably at least a couple of years away,” says Miller.

But the outlook for corporate bonds is not necessarily so positive. The economic slowdown is depressing the prices of riskier assets such as corporate bonds, because of the greater likelihood of corporate defaults.

“Looking at the pricing of 'risk' assets, financial markets are drawing an extraordinary degree of comfort from the stimulus packages from governments and their central banks. Arguably too much comfort,” says Miller.

Eric Stein, co-director of global income and portfolio manager in Eaton Vance's global income group, says the significant economic downturn we are experiencing will increase the default risk of corporate bonds.

He points to the widening of bond yield spreads that has occurred this year as proof of this. But also says quantitative easing—when governments pump money into the economy by purchasing bonds—should put a floor under corporate bond prices.

“The mere announcement of these programs by the US Fed and other central banks has been a big reason spreads of corporate bonds have tightened significantly in April, though spreads are certainly still elevated from where they were pre-Covid-19,” Miller says.

Bond strategies worth considering

There are several options for investors who want to boost their portfolio allocation of bonds. Some funds focus on government bonds alone, while others include a mix of corporate bonds and government bonds.

Fixed income remains an important driver of income along with portfolio diversification to help defend against share market volatility.

"In an uncertain environment and in a low growth world, the predictability of high-quality fixed income cashflow should be highly valued,” says Schroders deputy head of fixed income, Stuart Dear.

Even during periods of low yield, he says the diversification benefits of fixed income assets are "immense".

Dear says there are some good opportunities within the broader fixed income sector, especially in high quality credit, that now hold stronger appeal after the March sell-off.

“We’ve been de-allocating from government bonds and adding back to corporate exposures, both domestically and globally."

The Vanguard Australian Government Bond Index ETF (VGB)—which holds a Morningstar Bronze medal—tracks the Bloomberg AusBond Government Bond Index and is also available as an unlisted fund.

For investors also seeking exposure to the higher-yield of corporate bonds, the iShares Core Composite Bond ETF (IAF) aims to track the performance of the Bloomberg AusBond Composite 0+ Yr Index. The Fund invests primarily in investment grade fixed income securities issued by governments and corporate debt issues.

Wong also suggests the Morningstar Silver Medal-rated Colchester Global Government Bond Fund (40930) as an actively-managed strategy. The fund holds a global sovereign bond portfolio with a low correlation to growth assets such as equities and other fixed income securities such as credit and high yield corporate bonds.

Rising inflation risk

Inflation is one of the key risks Wong sees ahead, especially given the huge spending programs of governments in developed nations. These are expected to push up consumer spending—and eventually prices—after the coronavirus pandemic passes.

“An increase in inflation tends to be a negative for owners of government bonds as you’d expect interest rates to rise in response,” says Wong.

“Higher inflation lowers the real rate of return earned from owning fixed rate bonds.”

Consumer prices have risen faster in the March quarter than they have for several years, as annual inflation rose 2.2 per cent. Consumer pricing index annual inflation was above 2 per cent for the first time since 2018, and the highest since September 2014 quarter, boosted by some grocery and vegetable items.

But GSFM's Miller suggests falling energy prices should help offset rising inflation. Petrol prices dipped by 6 per cent during March, domestic holiday travel and accommodation costs fell by 3.1 per cent and international holiday travel and accommodation decline by 3 per cent.