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Bond losses mount in 'year of no return'

Fixed income markets are nursing their worst losses in years, setting the tone for a poor performance that is expected to continue against a backdrop of a recovering U.S. economy and a pick-up in inflation expectations.

Bank of America Merrill Lynch said this week that its global investment grade fixed income index lost 2.23 percent of its value in the second quarter – the worst quarterly performance since 1997 and potentially also the worst since the U.S. Federal Reserve starting lifting interest rates in the first quarter of 1994.


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And with the Fed tipped to soon deliver its first rate hike in nine years, while inflation expectations in the U.S. and Europe pick up, the tide appears to have turned against bond markets, where yields until recently were on a one-way track lower amid weak growth and easy monetary policy.

"We were always concerned that the coming rate hiking cycle could be as disorderly as 2004 – but never imagined getting this close at such an early point prior to lift-off," analysts at BAML said in a note published on Tuesday, referring to a "year of no return."

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"The big picture in our view remains that the unwind of the global liquidity trade has begun, and that means poor return performance and decompression," they added.

Heading for exit

Data released by BAML last Friday showed investors globally pulled $3.8 billion out of bonds funds in the week ending June 24. Government bond funds, which mostly invest in U.S. Treasurys, saw $1.4 billion of outflows.

The benchmark 10-year Treasury yield was trading around 2.38 percent on Thursday – about 80 points above a low hit earlier this year around 1.64 percent. European bond markets have also seen heavy selling that has only been capped by a crisis in Greece spurring demand for safe-haven debt.

Still, Germany's 10-year Bund yield is trading at about 0.85 percent – 80 basis points above a record low of 0.05 percent hit in April.

"We think the U.S. economy is recovering; we think the Fed is going to raise rates and we don't think that's properly priced into markets," Myles Bradshaw, ‎head of global aggregate fixed income at Amundi, told CNBC on Thursday.

"That has implications, particularly for the front end of the U.S. bond market, where we think yields are too low," he added.

The yield on two-year U.S. notes, which is sensitive to interest rate expectations, is trading around 0.63 percent.

Test

Thursday could bring a new test for bond markets with the release of closely-watched official U.S. jobs data. Any signs of strengthening in the labor market could reinforce expectations for a September rate hike, pushing bond yields higher.

Read MoreJune jobs report expected to be strong

Asked about his views on the outlook for bonds, Edmund Shing, a global fund manager at BCS Financial Group, told CNBC it was all about inflation.

"People focus so much on demand and supply, what you actually need to focus on for the long-term in the bond market are inflation fundamentals," he said on Thursday.

"If I'm right and inflation is creeping up in the U.S., then why shouldn't bond yields go up?"