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Tuesday, 25 June 2019

The rates conundrum

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This year the world economy may finally start growing again, eliciting fears that rates will not remain low for so much longer and leaving investors struggling to find ways to avoid the losses that a spike in benchmark yields could cause to bond portfolios

A customer looks at price tags at the vegetable section of a supermarket in Hefei

Source: Reuters

A customer looks at price tags at the vegetable section of a supermarket in Hefei

January got off to a heady start in Asia with high-yield issuers printing a record amount of dollar bonds. Even as some market observers saw the need for bigger coupons as one of the main drivers for such strong interest in junk bonds, investors themselves have been making a different argument to buy sub-investment-grade bonds. “The 64,000-dollar question now is if rates are going to back up or if they are going to continue to rise,” said an asset manager in Singapore.

Indeed, analysts said that the spurt in high-yield demand early in the year came from managers seeking to reduce the correlation to US Treasuries in their portfolios. Traditionally, rises in Treasury yields are a sign of risk appetite and a strong economic backdrop, both factors that favour gains in the stock markets and in junk bonds.

The flip side of it is that investors are also wary of buying investment-grade bonds, which are more likely to show paper losses if benchmark rates rise. This may explain why this year January saw roughly half the total issuance of high-rated dollar bonds verses same month last year. The number of three-year bonds in the investment-grade space has also been higher this time around, a sign that investors are avoiding duration risk, another way of safeguarding against a rise in rates.

Investors have reason to worry. The yield on the 10-year Treasury spiked in January, settling in a range of 1.85%-1.95%, 10bp wider than the range in which they were trading in December. On top of that, minutes of the US Federal Reserve’s December meeting showed a split board, prompting many shops to predict that the Federal Reserve would start withdrawing stimulus before the end of 2013 as the US economy shows signs of recovery.

The fact that the United States has been showing stronger economic data has filled the imaginations of credit analysts and portfolio managers. But with China still growing at its slowest pace of the past two decades and Europe and Japan fighting to break out of recession, it is not so clear that the hawks at the Fed will have the upper hand on the doves.

“I think the Fed will remain in easing mode and there will be fiscal headwinds to US growth which will keep a cap on yields,” said Rajeev de Mello, head of Asian fixed income at Schroders Investment Management. “I can see rates going up, but I don’t think bonds will go into bear markets.”

De Mello is not alone in his predictions. Other key asset managers such as PIMCO also think that benchmark rates will probably remain unchanged at least until next year. This has those betting on a rate rise on the edge as well.

But as investors try to predict how soon the Fed and the ECB will move, they may be hedging their rate risk in a dangerous way. The drop in yields of junk bonds has reached such an extent, that their correlation may be closer to Treasuries than to stocks now. “The view that ‘high yield’ is somewhat immune and that the danger lies in high grade may be the wrong conclusion at these historic 5%-6% yields for Double B credits,” said Owen Gallimore, head of credit strategy at ANZ.

Indeed, the correlation between the Merrill Lynch Asian Dollar High-Yield Index and the yield on the five-year Treasury, which most of the time is negative, hit the highest level in five years back in November at 0.85. It remained at 0.78 in early January. Meanwhile, the correlation of the index to the Dow Jones Industrial Average, which has been historically positive, was negative 0.71 in November.

Hence, analysts have been saying that the best way to hedge the uncertainty of the direction of rates is to bet in spread products. In its outlook for 2013, Morgan Stanley predicted a 50bp rally in average investment-grade spreads in Asia this year. The idea is that rising Treasury rates would not be fully reflected in bond prices, squeezing the spread.

The problem, however, is that CDS, the best alternative to place a spread position, is scant in Asia and where it exists, it is illiquid. Then, there is the issue again of being on the wrong side of the trade. If a sudden change in sentiment prompts Treasuries to rally, spreads could widen very quickly and the paper gains on bond holdings may not offset those losses.

As the chief investment officer of Western Asset Management Co noted in a January 23 comment: “In the 30 years preceding the (2008) crisis, interest-rate risk has swamped spread duration risk, clocking in at multiples of as many as 10 times during several stretches (…) Compare and contrast this with the current environment, in which spread duration volatility swamps interest-rate movements. Spread duration has exhibited moves of several hundred bps over the last few years.”

What this means is that being on the wrong side of a spread bet could be more onerous than holding a bond that drops as Treasury rates rise. This means that just as investors become more uncertain about the direction in rates, they are also finding it harder to protect themselves against a move in the benchmark bonds of the US, Europe and Japan.

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