Although the bond market won a recent reprieve following the weak US employment report and the unexpected fall in core inflation, with yields already low and the global economic recovery gaining traction, 2004 is shaping up to be a tough year for fixed income investors. Convexity, credit and duration, the three most fundamental areas of return for fixed income investors, are hardly attractive at current levels particularly considering that the long term secular trend in lower bond yields appears to be over. While the market is likely to remain trapped in a range for some time yet, the threat of deflation has receded and the risk of a break to higher yields is growing. One's position on the yield curve is therefore critical.

The US Federal Reserve, by continually pouring cold water on any speculation of an imminent rate hike, has basically put a lock on the shorter end of the yield curve. While implied volatility has fallen steadily since the yield on the ten year treasury spiked to 4.60 percent in the summer, growing concerns of inflation and the bubbling crisis of confidence in the weak US dollar, are likely to keep the yield curve steep for some time.

A position in the shorter three-year part of the curve makes more sense. The market is very divided about the valuation of the non-government bond market at the moment, which had one of its best years ever. US investment grade corporate bonds have on average paid 38 basis points a year over Treasuries. When looking at the market as a whole, particularly at the industrial sector, trying to gauge leverage from a pure debt-to-cash flow basis - which suggests spreads could tighten further - is not proving very reliable in terms of how the market is performing. The market is about as fairly priced as it could be, given that the bottom up story is basically fully discounted. In fact, the current environment does not seem to have taken into account some of the risks that could impede performance going forward. While the overall improvement in cash flows and profitability has been nothing short of impressive, corporations have also jumped at the opportunity to take advantage of stingy risk premiums and low interest rates. New issuance has surged as a result. Merger and acquisitions are also increasing, while the slump in capital spending is also largely behind us.

At the very least, volatility in the stock market, which recently fell to a seven year low, is likely to rise next year, particularly as the reality of the unsustainability of the recent surge in GDP growth begins to sink in. This will undoubtedly put credit spreads under some pressure. Nevertheless, given that interest rates are likely to remain low, the credit spreads should continue to trade on the tight side for now. The positive carry offered by corporate credit in such an environment therefore remains compelling, however, unlike 2003, where the rally in was largely directional, the key to adding alpha next year will be identifying relative value.

Kees van Beelen is a portfolio manager and a member of the investment policy committee for the Bank of Bermuda.