"Given less compelling valuations and the prospect of headwinds from higher interest rates, carry (income) will be a more critical component of total returns. This should augur well for High Yield bonds."
- Vasu Menon, Senior Investment Strategist, Wealth Management Singapore, OCBC Bank
- There has seen some fears that the impending Fed rate hike would cause a sharp bond market sell-off. This fear is misplaced when we look back at history. Examining the last hike cycle in 2004, the Fed raised rates aggressively – at almost a hike each month - from 1 per cent to 5.25 per cent. Remarkably, the U.S. 10-year Treasury bond yields were stable during the entire 2004 hiking cycle, trading between 4 to 5.25 per cent.
- Compared to the 2004 rates cycle, the current Fed is extremely dovish. Therefore, the Fed should be able to increase rates in December without causing a big sell-off in the bond market.
- Also, the resultant flows into the U.S. in the hunt for yield due to negative yielding assets in Japan and Europe are likely to restrain the rise in long term U.S. Treasury yields even if the Fed continues with policy tightening.
- While this should limit the increase in U.S. bond yields, it should not prevent it altogether. Accordingly, we see 10-year Treasury yields at around 1.75 per cent by year end, with further modest increases in 2017. This should mean that investment grade bonds offer slightly better returns than cash for the remainder of the year.
- Emerging Market (EM) bonds have had a resounding year and look set to surpass the second best ever annual return of 12.5 per cent achieved in 2010. Yet, the final leg of the race is likely to be a crawl rather than a sprint upwards as there are a few remaining obstacles such as the U.S. Presidential election in November and potential Fed rate hike in December. There are also few obvious catalysts within Emerging Markets.
- And so, we expect modest returns here on in which should be delivered largely from carry or income rather than capital appreciation. It’s worth noting that income looks to be an increasingly critical component of total returns given less compelling valuations, prospects of actual headwinds arising from higher interest rates and the absence of strong catalysts to drive Emerging Market economies going into 2017.
- Here, High Yield bonds -- where there is more of a buffer from the credit spread component -- are better-positioned to outperform Investment Grade paper given the latter’s higher correlation with U.S. Treasuries and lower credit component of total return.
- We would continue to focus on specific country, sector and individual credit bets as the primary driver of outperformance in a return environment likely to be dominated by carry.
- While we remain constructive on the EM High Yield in general, investors should be both circumspect and selective as this risk-on environment tends to result in increasingly lower quality issuers. As such, we would maintain our preference for higher quality names despite less compelling valuations.
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