Fixed income is the right asset class to be in, but investors should be more focused on preparing for inflation, argues Andrew Wells, global CIO for FIL Investments International.

London-based Wells acknowledges general market acceptance that the eurozone has entered a period of lower GDP growth, which is translating into major changes in investors’ growth aspirations and asset allocation.

“What we are seeing in Europe at the moment is reassessment taking place,” he says, pointing to today’s altered paradigm for “risk-free” government debt, which as the key pricing point for all other asset classes is having a major knock-on effect.

He says investors still worry they have missed the boat in fixed income, given gains that have been made as interest rates have tumbled. “In fact,” he counters, “the Japanese example shows you that the yield curve can go flatter at the long-end, so there is that potential in Europe at the moment and we still believe that as an asset class fixed income is the right place to be.”

He says the environment for investing in fixed income today is about making sure you have exposure to the right governments, corporates and high-yield debt, as well as the right inflation protection.

“Part of what we are doing is changing the way people run their benchmarks to reflect the right level of risk balance, rather than a traditional level of risk,” he states. “We are trying to get people to think intelligently around what the base case of their investments is, whether it is equally weighted.”

Expecting a period of weaker growth for the global economy in 2012, Wells says the likely response of quantitative easing (QE) will inevitably lead to pockets of inflation, and adds that until you see a significant reduction in unemployment – especially in the US – QE will continue.

“People are losing sight of inflation,” he adds. “Inevitably policies overshoot because you can’t land these things on a pinhead. What will happen is there will be an enormous amount of money that finds its way into restricted markets and we will get price inflation in certain areas.”

Only last week Fidelity launched an emerging markets inflation fund, and Wells suggests that investors will need protection against the tail-risk of inflation.

“Inflation bonds are very complex and structured and there is value between the different markets,” he explains. “It is a great opportunity for people like ourselves who do all the analysis of the structuring to create value for investors and that is why we are seeing a lot more interest.”

He says the technicalities of investing in inflation-linked bonds globally, rather than domestically, means investors are increasingly outsourcing purchase and management of these products.

In terms of high-yield bonds, an area attracting traditional equity investors in increasing numbers, he points out that as investment banks have shrunk they have taken liquidity out of the system, meaning much of the premium for high-yield is not for default but for illiquidity.

“That is why we think [high-yield] is still a very good investment class to go into because if you can pick up that liquidity premium by investing longer term, [the market] will come back,” he says.

At the same time Wells warns of the danger of investing in bonds that are dropping down the ratings scale. “There are a lot more banks, in particular in Europe, that are being downgraded. I would not be a normal buyer of that.

“But if you look at some of the high-yield names in Asia, many of them are state-sponsored, national champions. We think a balanced name-by-name basis is a better approach. High-yield is a name game.”

On the subject of Europe’s sovereign debt woes, Wells says the markets have already priced in a restructuring for Greece, but problems may emerge in the market for credit default swaps (CDS).

“[Greece] in itself is not a big issue. What is a big issue is how [authorities] deal with CDS in that process and whether it is a technical default or some kind of soft default, and what that means for the rest of the market place.

“We have seen a lot of volatility around CDS as an instrument. The danger is clearly that if they do some restructuring and it doesn’t trigger a default, then the whole CDS market will lose some of its relevance in financial markets, and I think this could be very unsettling.”

He says the most serious repercussions could emerge in CDS markets for Italy and Spain, two countries that have begun to dominate the risk in European portfolios because of the spread and quantum of debt they have outstanding.

Wells points out that an institutional investor who bought a European aggregate bond fund or index in 2007 was buying a diversified basket of risk, balanced between asset classes.

“If you were to put one euro in a bond fund four years ago you would have had this nice diversified set of risks. But now over 50% has this cliff-risk of Italy and Spain [because of their rising contribution to duration times spread].”

In a similar vein, he says that five years ago a US aggregate bond index was made up of about 27% in US Treasuries. Go forward three years and he predicts it will be 65-70%. “People need to readdress and look at what they are investing in because what they originally bought is not what they have currently got.”

He notes that Fidelity is working with investors in Germany to create a portfolio of European government debt, adding other sovereign debt and AA rated corporates and making it equally weighted rather than determined by the amount of issuance and bond spreads.

“That kind of thing is just changing the market completely, because what it will mean is these guys that need to do all the issuance won’t have a natural audience. Each of the sophisticated investors will have their own equally balanced benchmark and they will invest on that basis.”

He agrees that problems in Europe are driving investors towards Asia and emerging markets in a risk-on, risk-off fashion (i.e. during risk-off they sell European assets, and in risk-on they head into Asian and South American markets).

He says a reasonably sophisticated investor in Europe may still only have 6-8% of investments in Asia, a figure he believes will need to be closer to 20% in the longer term. He also notes that he is seeing far more Japanese investors investing overseas at present, spurred by a strong yen.