“Valuations on high yield bonds do not look compelling currently. However in a reflationary environment, high yield bonds should be better insulated from the adverse impact of higher rates”
- Vasu Menon, Senior Investment Strategist, Wealth Management Singapore, OCBC Bank
- U.S. bond yields have stalled as the market awaits more clarity on the direction of policy. The Fed seems likely to raise rates again, possibly by June, but uncertainty is greatest on fiscal policy where details of planned reforms are sparse.
- 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.
- However, the minutes of the most recent Fed policy meeting suggests they are not worried about the risk of overshooting targets for unemployment and inflation. As such, gradual tightening still seems like the most likely scenario.
- The minutes of the most recent policy meeting also show that the Fed is preparing for a formal discussion on shrinking its balance sheet, ie quantitative tightening. Initially this will happen by ending the reinvestment of proceeds from maturing bonds and it seems likely to start in 2018. A smaller Fed balance sheet implies a higher risk premium for U.S. Treasuries and there is a risk that this has an impact akin to former Fed Chair Bernanke’s infamous “tapering” remark in May 2013.
- Despite higher interest rates, we continue to see opportunities in bond markets. We stay positive on Developed Market and Emerging Market high yield bonds. The pick-up in growth bodes well for high yield bond issuers and if Trump were to enact his expansionary fiscal policies, it would be conducive for high yield bonds. Besides, oil prices are now less of a drag on the sector.
- In the face of potentially improving fundamentals and a lower default rate, the downside for high yield looks limited - even as the Fed proceeds to raise rates - given the spread cushion it enjoys. High yield bonds still offer investor good carry to tide through this period of uncertainty.
- We reiterate that 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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