“In the face of potentially improving fundamentals and a lower default rate, the downside for high yield bonds looks limited - even as the Fed raises interest rates.”
- Vasu Menon, Senior Investment Strategist, Wealth Management Singapore, OCBC Bank
- The deflation risk of recent years that has had central banks in developed economies pursuing ever-more radical policies is fading. Firmer growth and a rebound in commodity prices are pushing inflation higher, so attention is turning to when stimulus will be withdrawn. This will become an issue for Europe and Japan as the year progresses, but the United States is leading the shift.
- We continue to expect the Fed to raise interest rates three times this year and another four in 2018. The economy is at full employment and inflation is only marginally below the 2 per cent target, so the Fed should be uncomfortable with interest rates around 2.5 per cent below neutral levels.
- Of course the Fed does not operate in a policy vacuum and must be sensitive to any changes from the new Trump administration. The most obvious risk is that fiscal stimulus boosts growth and raises inflationary pressure, which would demand a more aggressive response from the Fed.
- The bond market has already started to respond to this new outlook for policy, and we can expect yields to push higher as the Fed gradually tightens. We see 10-year U.S. Treasury yields around 3 per cent by end-2017. Investment grade bond returns will be dull in this environment and we have cut our stance to neutral, preferring to take some credit risk in high yield bonds
- Despite higher interest rates, we continue to see opportunities in bond markets but returns will not be as high as in 2016. High yield bonds should remain in vogue as the search for yield continues. Ageing demographics and surplus savings should support the continued search for yield.
- Valuations on neither High Yield nor Investment Grade look particularly compelling currently. However in a reflationary environment with higher rates, we believe that coupon/carry will become an increasingly important component of total return. With its higher corporate spread component, High Yield bonds should be somewhat better insulated from the adverse impact of higher rates. Furthermore, High Yield is better positioned to benefit from a decline in overall default rates in 2017 versus 2016.
- There are three things to bear in mind when investing in bond markets to reduce risk. Firstly, given the potential for higher U.S. interest rates, investors should focus on bonds with a shorter tenor as such bonds are less affected by higher interest rates compared with longer dated bonds. Secondly, consider investing in a portfolio of bonds through a unit trust rather than buying individual bonds as many individual bonds require a significant investment outlay and can expose investors to concentration risk. Finally, it is absolutely imperative to buy only into bonds with decent credit fundamentals to reduce default risk.
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