Kames Strategic Global Bond managers Philip Milburn and David Roberts have warned that five year US treasuries look vulnerable to even a hint of a potential US rate hike later this year.

A key strategy within the government bond portion of the fund is a short on five year US treasuries versus a long on thirty year treasuries, which Milburn (pictured) described as one of the critical fund positions for 2014.

The Citywire + rated pair remain wary of interest rate risk and the fund is underweight benchmark duration at around 2.5 years. They also still have no exposure to index-linked bonds.

Milburn said: 'We still do not like interest rate risk or duration in the fund. We like thirty year treasuries because we think they have been oversold and endured the brunt of recent tightening worries since last May.’

'We don't know exactly when the US will raise rates but it will happen. The short end has been better anchored so it has been tricky to short two year treasuries but we think five year treasuries could easily lose its anchor and start to unwind.'

Roberts added: 'There is little evidence of a US policy rate hike in 2014 and we see the value in 30-50 year treasuries. We expect the market to start pricing in the possibility of a rate hike out to about five years and are concerned about the amount of money in short-dated bond or cash funds.'

While the pair expects government bond returns as a whole to be negative this year, they believe the income derived will produce a total return of between 0% and 2%.

Another key position is a short on the Canadian dollar versus a long on the US dollar. This is as the managers believe recent outperformance by the former will soon revert back to its long term average.

The pair continues to prefer Belgian government bonds to their French counterparts.

Still wary on EMD

The duo is wary of emerging market debt, however, and is waiting to see further downside volatility before increasing exposure again.

Milburn said: 'We see emerging markets as the biggest swing factor in 2014 for equities and fixed income alike.’

‘We are only buying emerging market corporates in hard currency earnings, such as Chinese oil majors, and need to see more turmoil in EM before we increase exposure.’

'There is still room for further spread widening and pressure on currencies and EM will remain rate sensitive. Our bearishness has been hugely reduced however largely [due to the] cheaper valuation argument.’

Around 40% of the fund is in investment grade bonds and the pair continues to prefer US high yield to European, with some 20% of the funds invested in high yield overall.

They expect a 2014 return of 4-7% for the sub-sector, with B rated bonds in a sweet spot.

Milburn said that the good news for high yield came from the relatively benign economic backdrop but this was tempered by the fact that cash prices in high yield looked fully valued.

Wary of eurozone recovery

The pair remains wary of eurozone corporate bonds despite a belief that the region is recovering 'slowly but surely’.

Milburn said: 'There have been some structural improvements with Spain and Italy, which helps the economy and flow of funds but we think that with growth still fragile we are not ready to pile back into corporate bonds just yet.'

He has added selectively in peripheral Europe, however, buying some Telefonica debt and a couple of high yield plays in Italy and Spain but he still has no exposure to Greek or Cypriot debt.

'Italy still has further to go but it is wealthy and can service its debt. We are more tentative overall on Spain, although we will add selectively there. We are dipping our toe in the periphery but it's too early to go firmly in.'

A bond in Portuguese energy producer EDP bought around nine months ago has now been sold after strong performance.

'It is Portuguese but its main exposure is to Brazil and we sold it after it tightened 25 basis points in a day. '

Over three years to the end of December 2013, the global strategic bond fund has returned 18.2% versus a 9.7% return by the average manager in US dollar terms.