Government bonds will remain a major investment theme in the current economic environment as the extent of the global slowdown will continue to fuel the need for substantially lower interest rates, according to Quentin Fitzsimmons, head of government bonds for Threadneedle.

"With high levels of market volatility continuing to persist, we foresee a significant range of investment opportunities, as lower bond yields result in capital gains and income enhancement," says Fitzsimmons, during a visit to Hong Kong. "In fact, government bond yields look even more attractive after the equity rally. False liquidity has led to a chronic mis-pricing of risk in credit markets, and yield spreads have now begun to look interesting."

Fitzsimmons  believes that deleveraging in developed markets -- a theme that dominated the financial markets last year -- is still feeding through to individuals as economies remain depressed, making people's ability to borrow greatly constrained. Government bonds will remain a safe haven for investors until the deleveraging process is complete, he adds.

 In this environment, Fitzsimmons notes the real issue is not inflation, but the increasing possibility of deflation. 

"Recession brings with it rising levels of spare capacity, weak wage bargaining, and potentially a period of much lower inflation than is currently consensus. We think that the risks of deflation are being underestimated," he says.

Overall, Threadneedle continues to believe that: interest rates will remain low for a considerable period and quantitative easing will be required for some time to come; inflation is not an issue but the risk of deflation is high; stock specific risk in credit remains very high; and strategies using liquid instruments remain desirable. 

Fitzsimmons notes that government bonds have sold off significantly as investors run from the heavy supply and soaring deficits. Looking ahead, he says the short-term picture for government bonds is difficult, but the truth is they offer more value than many think.

"We are overweight credit especially high yield, but the rally in spreads is starting to look mature. However, government bank guaranteed debt, a new asset class as a result of the credit crunch, offers extra yield over governments at no extra risk," he says. "The US dollar is likely to continue do well given better stimulus and recovery in stocks and short-dated credit spreads are very attractive as a balanced way of maintaining credit quality."

Taking a longer term view, long-dated bonds are looking more attractive in the US and Europe because of the steepness of yield curves, he says.

"Strategically, we need to consider how to tilt our investments towards higher spread opportunities," he says. "So far this has been done by extending the maturity of a proportion of the high-grade portfolio into government-guaranteed issues."

Competitive devaluation policies will continue to occur, bringing considerable international political conflict and risk of protectionism, says Fitzsimmons, adding this brings forth opportunities in the currency markets, where overall uncertainty is high, requiring flexible and adaptable strategies.

"It is clearly impossible for all countries to export their way out of trouble by devaluing simultaneously," he says.

Fitzsimmons manages a number of fixed-income portfolios within Threadneedle's target return fund range, which aims to deliver positive returns over the medium term, regardless of market conditions.   

"In any environment of great uncertainty we strongly recommend investors look to an absolute return strategy as having the flexibility to go short as well as long and exploit trends in volatility and areas of added flexibility compared with traditional long-only bond products," he says.

The Threadneedle target return strategy was established in 2005 in response to investor demand for absolute return strategies amidst increasing uncertainty about the prospects for investments in equities and corporate bonds, since they offer diversification to traditional equity and bond markets and yet provide daily liquidity to investors. As of end-March 2009, Threadneedle managed more than $986 million in target return strategies.