Investors will do well to position defensively, by reducing duration and avoiding illiquid local currency markets, as volatility in Asian bonds is set to continue until 2016, according to Magdalene Teo, Singapore based fixed income analyst at Julius Baer.
She ascribes the changes in the fixed income market over the past two months to the mixed messages that US Federal Reserve chairman Ben Bernanke has sent the market.
“We believe the key reason that he is allowing the volatility to rise is so that he can curtail leverage, as he was concerned that cheap money was increasingly being channeled into financial leverage outside the regulated banks and also with the exaggeration in credit valuations. Yields rose from 1.62% to 2.7% and when that happened he became more comfortable and came back to the market with a change in tone last week," she said in an interview with Asiamoney PLUS.
“The volatility presents interesting entry points for real money investors – those who are not buying on leverage or on a carry basis. Valuations have come to an interesting level; the JACI [J.P. Morgan Asia Credit] index widened from 4.0% to 5.6% and has fallen again to almost 5%.”
Teo expects volatility to continue as rates begin to normalise and growth across Asia slows during the next few years.
Strong local sponsorship has made the Asian market more resilient than other emerging markets such as Latin America; the local buy is very strong in Indonesia and the Hong Kong investors have a preference for China property names, she said. The year-to-date allocation of primary issues to Asian investors is around 62%.
However, the fact remains that Asia is a component of the emerging market asset class. This means that a recovery in the US will lead to further outflows from the region’s bond markets.
“If you were to see the differential between growth in the US and in emerging markets changing in favour of the US, we would continue to see capital outflows back to the US. In the current environment investors have to be watchful which segment of the fixed income market they are investing in,” she said.
“Hard currency looks more attractive as we are still mindful of outflows in the emerging market local currency space, simply because the carry trade is not looking that attractive, especially with the increased volatility and without the assurance of lower rates.”
Short-duration
Within the US dollar space, she says she will not be rushing into long duration as the US could begin to taper its quantitative easing programme sooner rather than later, which will have a negative impact on the long end of the curve.
“The curve has become very important. We believe that the Fed will only raise rates in 2016. Today’s five-year bonds will only have two years duration left at the time of the first rate hike and so we recommend holding five-year bonds,” she said.
“Two or three-year bonds are very safe and haven’t really moved much, but during the sell-off, the belly of the curve (three to seven years) was most impacted and some of those bonds are looking rather attractive, as they shouldn’t have sold off in such a big way.”
She also believes that once the primary market kicks off again in Asia, this will improve the technicals further. This has already started to happen over the past week and the curve is beginning to normalise.
Within the hard-currency, five-year space, she says it is important to be very selective and to avoid sectors that are particularly prone to a sell-off.
“We have to bear in mind that as the Chinese government balances reform and growth, this will have an impact on the real economy and will affect the credit quality of the issuers. You should not throw everything out, but you do need to differentiate, even between the state-owned-enterprises (SOEs),” she said.
“The default rate is expected to be 2% according to Moody’s, because of low levels of upcoming maturities. So I’m not too pessimistic, but as China slows down we may have some stress points along the way.”
Within the high yield space she likes non-cyclical companies in the utilities and telecommunications sectors as the income is fairly resilient. In terms of new issues she likes high yield because a cushion of more than 5% should allow investors to manage volatility.
“We’ve also got to watch out if these Asian based issuers have at least partially hedged their foreign currency liabilities on the back of a stronger US dollar and higher rates. If they have done so then they might be vulnerable to a further sell off as liquidity moves back to the developed markets, but in general they should survive quite comfortably.”
Finally, she is constructive on offshore renminbi, or dim sum bonds, due to their relatively low duration and the stability of the renminbi. “In the May and June sell-off most asset classes lost their year-to-date returns. Only two escaped that – one is RMB bonds and the other is US high yield,” she said.