Bonds (April 2017)

Prefer High Yield Bonds

“We prefer high yielding bonds where higher income can provide a cushion against rising interest rates and heightened uncertainty. High yield credit offers an interesting opportunity given the recent widening of credit spreads.”

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

  • Stronger growth brings the prospect of monetary policy tightening. This is most apparent in the U.S. where we think the Fed is set to raise interest rates six more times by the end of 2018. However, it also applies to China, which is trying to cool down the housing market, and even to Europe and Japan which are likely to be signalling a shift in monetary policy before the end of 2017. In a year’s time G3 monetary policy will still be very loose, but the lengthy era of zero interest rates and abundant liquidity is slowly drawing to a close.
  • There is the risk that an aggressive tax reform programme by the Trump administration may intensify concerns about overheating and drives the Fed to be more hawkish. However, the current political timetable implies that this is more likely to be an issue for 2018 rather than this year, and it is unclear whether tax reform will provide a significant fiscal boost. The collapse of healthcare reform suggests that the fiscal conservatives in the Republican Party could block policies that increase the budget deficit.
  • Despite the prospects for higher interest rates we continue to be positive on high yield bonds. Bonds as an asset class arguably benefits more directly from strong underlying growth than equities. Equity markets have high growth expectations to live up to; bonds only have to remain creditworthy. That is much less of a challenge in a benign economic environment.
  • Valuations on both high yield and investment grade bonds currently are rich by historical standards. However in a reflationary environment with higher rates, we believe that income from coupons 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 bonds are better positioned to benefit from a decline in overall default rates in 2017 versus 2016.
  • Finally, we reiterate three key 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 quality bonds with decent credit fundamentals to reduce default risk.