Bonds (May 2017)

High Yield Bonds Still Preferred

“Valuations on both high yield and investment grade bonds are near post Lehman highs. However in a reflationary environment with higher rates, we believe that coupon will become an important component of returns, hence we prefer high yield bonds”

- Vasu Menon, Senior Investment Strategist, Wealth Management Singapore, OCBC Bank

  • The market seems to have taken the Fed signalling that it running down its balance sheet from the end of the year as an indication that interest rates will not need to rise as much as suggested in the “dot chart”. However, the balance sheet discussion took place in the same policy meeting that produced the dot chart. It is not a choice of either raising rates or shrinking the balance sheet – the Fed intends to do both.
  • In our view, the balance of risks has changed substantially, which points to a steady normalisation of policy. The jobless rate is already below the Fed’s estimate of full employment, while inflation is close to target. Even allowing for an apparent readiness to accept inflation overshooting the 2 per cent target, the Fed needs to be sensitive to the idea that interest rates are about 2 per cent below neutral levels.
  • As a result, we expect two more rate hikes this year (June and September). After the start of balance sheet reduction in December, we see another four hikes in 2018, to take policy close to neutral. This path for tightening would be much slower, and much later in the cycle than normal, which reflects the unusual challenges that have faced the economy.
  • So far the Fed has not responded to news on fiscal policy, as there is still no credible plan. However, it must be sensitive to the risk that a debt-funded tax cut will be inflationary at this stage in the economic cycle. Even if tax cuts are not scheduled until 2018, monetary policy works with a lag, and needs to be forward-looking, so it could influence Fed policy before the end of this year.
  • Investment grade bonds have lacked strong drivers in recent months as the reflation trade has faded. However, we see yields rising through for the remainder of this year as the Fed pushes through two more rate hikes and offers details on how it will shrink its balance sheet. Consequently we have turned cautious on developed market investment grade bonds.
  • We continue to prefer High Yield bonds which should be somewhat better insulated from the adverse impact of higher interest rates. Furthermore, High Yield bonds are better positioned to benefit from a thus far substantial decline in overall default rates in 2017 versus 2016.
  • Finally, 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 (preferably five years or less) 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.