SINGAPORE (Sept 10): Bond prices generally fall during rising interest rate cycles, while their yields expand. Still, there are strategies available to bond fund managers as they navigate the US Federal Reserve’s rate-hike cycle. Since December 2015, the US federal funds rate has risen to 2%, from 0.25%. The Fed has been very clear in its guidance, which points to two more rate hikes this year, bringing the FFR to 2.5%, and taking the total to four rate hikes. Two rate hikes have already occurred this year, and a third is due this month, with the fourth likely to be scheduled towards year-end.
Next year, the Fed could implement a further three rate hikes. US data continues to show a growing economy amid rising inflation. The US inflation rate for the 12 months to July 31, 2018 is 2.9%, according to the US department of labour. US GDP growth for 2Q2018 was revised up to 4.2%.
Although the US is in a rate-hike cycle, other developed economies are in different cycles. The European Central Bank has signalled that its rates are likely to remain “steady” till the summer of 2019, indicating that EU interest rates are unlikely to rise for the next nine months.
This provides fund managers with opportunities, according to Holger Mertens, head portfolio manager, global credit, Nikko Asset Management. “Interest rate cycles globally are not synchronised.” As Mertens sees it, the places to hide from rising US rates include Europe, Asia, the short end of the US investment grade market and US high yield.
The main flagship fund for Nikko AM is the Global Credit Fund, benchmarked against the Bloomberg Barclays Global Aggregate Bond Index. Mertens says the fund is able to take an off-benchmark position in that it does not track the Global Aggregate Index to a tee. In the index, two-thirds of the components are US credits.
“We would like to see the world more holistically and more globally, investing more along the lines of how the world looks GDP-weighted. And how this looks is: ⅓ US, ⅓ Europe and ⅓ Asia,” Mertens says.
China looms large in Barclays Global Aggregate Index
Interestingly, in March, Bloomberg announced that Chinese renminbi-denominated government and policy bank securities would be added to the Global Aggregate Index, once several planned operational enhancements are implemented by the People’s Bank of China and Ministry of Finance. The Chinese securities are likely to be phased in over a 20-month period starting from April 2019.
According to Bloomberg, China has the third-largest bond market globally. Eventually, the Global Aggregate Index’s local currency Chinese bonds will be the fourth-largest currency component, following the US dollar, euro and Japanese yen. Using data as at Jan 31, 2018, the index will include 386 Chinese securities, which represent 5.49% of the US$53.7 trillion ($74.1 trillion) index.
Already, Mertens has focused his attention on Asian credits, of which China’s are the largest in the fund. “We probably have a higher weight to the Asian markets versus competitors because we also have the research expertise for the market with the team in Singapore. So, although we do what everyone else is doing in continuing to look for opportunities in the US, we also look for opportunities in Asia,” he says.
One of the themes in Asian credit is Chinese state-owned enterprises (SOEs). Mertens sees these as safe investments. “We think the Chinese government will support these bigger companies because they are critical for the Chinese economy. We are quite comfortable with [holding] these Chinese credits,” he says.
One way to look at Chinese SOEs is to rank them in order of importance to the country. The higher up the ranking, the better the credit quality. “The likelihood of your getting paid back is very, very high,” Mertens says.
Bond Connect, which started in July last year, has made it simple to buy and sell Chinese credits. A joint venture between the China Foreign Exchange Trade System and Hong Kong Exchanges and Clearing, this is a new mutual market access scheme that allows investors in China and overseas to trade in each other’s bond markets through connection between China’s and Hong Kong’s financial infrastructure institutions. These are mainly the large Chinese banks and a handful of foreign banks, including HSBC Holdings and Standard Chartered.
Asian credits are also interesting from a yield and duration angle. They have the same yield as the US but are of a shorter duration. For instance, seven-year US credits are priced at a 4% yield, whereas Asian credits priced at 4% mature in four years. “So, Asian credits are 2½ years shorter in duration than US credit,” Mertens says. “For Asian credits, you don’t have to [buy into lower yields] but you can reduce the duration.”
Even when investing in SOEs and Asian credits, Mertens will consider only those that are in hard currencies, which are mainly US dollar-denominated bonds and some euro, Canadian dollar and Australian dollar bonds. Of course, when the Barclays Index introduces RMB bonds, that could change.
Mertens is not interested in Japanese bonds even though the Bank of Japan maintains an accommodative policy. It is a difficult market for getting hold of investment-grade bonds, he says. “The few corporate bonds that are around are chased by the domestic investors, so it doesn’t make sense for us to chase the bonds.”
US high-yields safe at present
According to Mertens, US high-yield credits are quite safe for now despite the flattening of the yield curve — which is the spread between two-year US Treasuries and 10-year bonds. Usually, such a trend points to a recession.
“At the moment, we can’t see any signs pointing to a recession. The US economy is pretty strong. Short-dated bonds are yielding 3.5% for 2½ years and, if you have a breakeven of 140 basis points, rates have to rise more than 140bps before you start losing money on short-dated bonds. This is a pretty good cushion,” Mertens says.
Another place to hide is US high-yields. While returns on treasuries have been negative so far this year, US high-yield bonds continue to do well. “This is similar to other periods in which rates were rising and high-yields were outperforming,” Mertens recalls. The reasoning is this: If both rates and inflation are rising, the economy is doing well. Spreads are getting tighter (bond yields are compressed) because credit quality is improving. “This is exactly what we are seeing now. High-yields work as a cushion in an environment in which rates are rising,” Mertens explains.
So, although high-yield bonds are seen as being relatively more risky than investmentgrade ones in general, at this point in the US economic cycle, they should be quite safe. In essence, Mertens is decreasing interest rate risk and taking on more credit risk with this off-benchmark strategy.
He is also looking to identify “rising stars”. This is a global trend in which companies get upgraded because of better economic growth. The most important upgrade is from a BB to BBB, because that takes the company from high-yield to investment-grade.
Financial sector shows most promise
In the US, the financial sector is benefiting from two broad trends — higher rates and higher leverage. Both should underpin earnings growth by banks. In addition, the sector should remain relatively stable because the banking sector is tightly regulated at present, with a global financial crisis (GFC) unlikely.
Furthermore, US President Donald Trump’s administration plans to lift some of the regulations under the Dodd-Frank Act. Deregulation could improve efficiency, analysts say.
“We’ve seen a significant increase in the capital that banks are required to hold since the GFC and, with all the additional regulations imposed on the banking sector, it’s a much safer place than it was 10 years ago,” Mertens says. “At the end of the day, banks must be in a position to make some money, attract private capital and lend.”
In Europe, some governments, including Germany, are pushing back on the regulations being proposed in Basel IV.
In other strategies, Mertens took a position on UK retail in 2016, which is turning out postively. “After the Brexit referendum, we took an underweight on the UK retail sector and this has worked pretty well. But it’s hard to say whether [it worked well] because of structural shifts in retail or because of Brexit. This was the only position we took: that the referendum could have a negative impact on disposable income.”
At any rate, the trend of high street moving to online is broad-based globally. “We don’t see the stress in the credits in European retail that we see in the US, but the pressure is on the companies to come up with strategies for the structural shift,” Mertens says.
Whatever the case, he expects to meet his target this year. “Since inception, we have outperformed the [Global Aggregate Index]. We are aiming for 150bps outperformance [this year] and we’re on track to do that.”
