Fixed Income - The search for yield continues
“Globally, there’s probably a rather troubled three years ahead in terms of simple passive bond investments. Interest rates are likely to rise in this period and that will make life difficult for traditional investment styles,” says Tim Haywood, investment director for fixed income at GAM, an investment manager with around $53bn under management.
“We now have to build into our portfolios – and have started to do so – long term protection against dramatically higher yields in dollar markets,” he says, noting comments at the US Federal Reserve’s May meeting spurred a strategic rethink.
The big selloff At the May meeting, the Federal Open Market Committee raised the prospect it would change the pace of its bond buying for its quantitative easing programme, currently around $85bn a month. Comments from US Fed Chairman Ben Bernanke indicated the pace of bond buying could slow over the next few meetings, depending on economic data. As a result, fixed income globally hasn’t exactly had a summer of love, hit by a broad-based selloff amid hand-wringing over whether and when the Fed is set to begin tapering, as well as yo-yoing economic data from regional growth driver China.
Conditions in the global fixed income markets stabilised after Bernanke clarified that tapering bond buying wouldn’t necessarily affect the Fed’s benchmark interest rates, which are viewed as likely to remain low for at least another year.
But the turmoil spurred net outflows of $1.51bn from US-based emerging-market bond exchange-traded funds in June, for a year-to-June net outflow of $1.16bn, according to data from Morningstar. Open-ended emerging market bond funds based in the US saw net outflows of $2.72bn in June, although for the year-to-June, they have seen net inflows of $5bn, the data show. Among UK-domiciled funds, global emerging markets local-currency fixed-income funds saw net outflows of £183.3m ($283m) in June, the data show. Morningstar doesn’t have an Asian bond fund category.
Opportunity to buy Still, the economic outlook didn’t justify the selloff and some managers took this as an opportunity to buy. The selloff was indiscriminate, says Jana Velebova, who handles emerging markets at global fixed income specialist Rogge Global Partners, which has around $54bn under management.
“It’s quite preliminary to call the end of the era for bonds globally; we don’t see a very sharp selloff in US Treasuries for now; it’s going to be very gradual,” she adds. Velebova notes there has been no substantial economic growth pick up or signs of inflation to justify the selloff; she believes bond pricing is much more attractive now than earlier this year.
BlackRock’s research showed Fixed Income flows improved to $6.4bn in July following outflows of $8.4bn in June. Investors displayed some risk appetite, adding $2.6bn to High Yield on the back of June redemptions of $2.2bn. However, about half of July’s investments were made in short maturity funds which are less sensitive to interest rate movements.
“We’re looking where markets have gone too far,” Velebova says, adding that she sees value in places where “unsubstantiated” interest rate hikes have been priced in, as much of the region faces below-potential growth and a benign inflation outlook. While the market is still seeing some volatility, she believes Thailand, Malaysia and Korea are pricing in interest rate hikes that aren’t on the cards. But Indonesia does not make her list for potential bargain-hunting, with the central bank there already beginning to hike rates. In mid-July, Indonesia’s central bank surprised the market by raising its benchmark rate by 50 basis points to 6.5%, rather than the 25 basis point rise which was expected. Bank Indonesia has raised rates over its past two meetings as the country faces capital outflows and a weakening local currency, with the rupiah down nearly 7% against the US dollar so far this year. “It’s at a very different stage of the cycle; interest rate hikes priced in the curve are actually quite reasonable.”
GAM’s Haywood also sees opportunities in the selloff. “The summer turmoil in bonds has allowed us to cherry pick some bonds we didn’t think we were going to get at such prices,” he says, but he notes GAM doesn’t see a lot of value in Asia’s sovereign space.
“The problem for the Asian government bond markets from a global, traditional, perspective is that they are not hugely attractive,” he notes, as they are either somewhat illiquid or not yielding very much, with rates across the whole region expected to remain fairly low for many quarters.
Growth in Asian economies also may not live up its previous heated pace. “The changes in growth expectation, for the first time in decades, are mostly being seen outside the Asian region,” Haywood says.
‘Barbell’ in corporate credit GAM sees better opportunities in parts of the Asian credit space, with better entry points on yields. Amy Kam, an investment manager at GAM, is recommending a “barbell” positioning in Asian credit, balancing high-quality credits in Singapore and Korea with high-yielding Chinese property bonds, noting those are performing well operationally.
Kam also recommends reducing duration as interest rate increases loom. But she adds she’s not keen on the gap in the middle, especially BBB names from China, noting that in addition to fundamental concerns, there’s a heavy pipeline and supply-side risk. Malaysian and Thai BBB-rated bonds in the bank, oil & gas and palm oil segments also don’t offer much value, Kam says.
Baring Asset Management is staying positive on the outlook of another riskier asset class, high yield bonds, and its ability to continue deliver attractive returns in the coming months.
An increase in US rates would be challenging for the wider fixed income asset class, Ece Ugurtas, Investment Manager, Baring High Yield Bond Fund, wrote in a recent note to clients, but added “it is important to recognise that high yield is one of the least interest rate sensitive parts of the fixed income universe.”
Returns from the asset class are more impacted by the underlying fundamentals of issuing corporates, Ugurtas said. Emerging market high yield corporates also offer interesting opportunities given that such bonds typically offer a higher yield than similarly rated credits in the developed world, but with lower levels of issuer debt and improving corporate governance. “We also recognise that emerging market central banks generally have more scope to introduce pro-growth policies to support economic activity as and when required.”
Japan’s economic experiment The Bank of Japan’s massive efforts to stimulate the economy with QE measures and moves by Prime Minister Shinzo Abe’s government to restructure the economy present special issues for investing in Japan’s bonds. Abe’s economic programme, known as “Abenomics,” includes advocating an inflation target at 2% a year, halting excessive yen appreciation and introducing radical QE. BoJ Governor Haruhiko Kuroda has vowed to take unprecedented monetary stimulus, to double the money base within two years to battle deflation and jolt the economy out of its prolonged slump.
“In Japan, we have the fascinating economic experiment, which if successful, should cause bond yields to rise. If unsuccessful, it may also cause a panic about the debt stock and bond yields to rise,” says GAM’s Haywood.
While some fund managers have a doomsday scenario for Japanese debt, including US hedge fund manager J. Kyle Bass at Hayman Advisors, Haywood doesn’t see this outcome as very likely. Bass has said the Japanese central bank’s bond-buying exercise, while massive, still isn’t large enough to keep the country’s medium-to-long term rates stable. Haywood notes GAM has “very few” investments in corporate Japanese debt, outside of a bearish bet on some of the consumer electronics names, placed by buying credit protection on them. But he notes GAM has made some profitable bets on Japanese convertible bonds.
Trends to watch ahead Rogge is monitoring the efforts of some of emerging Asia’s biggest markets to open up for foreign investment. “China and India are some of the biggest local markets in the emerging market universe, but they’re not high on investors’ agenda or widely represented in investment indices as they still have substantial capital controls and investment restrictions,” Velebova says.
She notes that Asia currently makes up close to 30% of JPMorgan’s government-bond-index emerging market global diversified index, but without capital market restrictions, it would make up about half.
Velebova sees quite a few moves from both China and India to gradually open up their markets, with China moving to internationalise the yuan. In India, authorities appear to be considering greater access, but they haven’t taken tangible steps yet. Rogge is investigating how to enter both markets. She adds that many emerging markets globally are trying to attract more money, noting Brazil recently removed a tax that offered a hurdle to investors in that market.
“Liquidity is not as abundant any more; it’s much more of a competition for global capital, or there will be going forward,” Velebova says. “So markets needing to attract money are making it easier for investors to come in and participate.”