Koh Liang Choon, head of fixed income at Nikko AM Asia, says the region’s bond market is still growing fast on the back of higher demand and supply. He is raising exposure to US dollar-denominated corporate debt and may lengthen the duration of his portfolios.

SINGAPORE (Feb 24): Investors have spent most of the last two years waiting for interest rate action. The US Federal Reserve’s decision to raise the federal funds rate by 25 basis points in 2015, for the first time in nearly a decade, was probably the most anticipated financial event of the year. Then, in 2016, it took a whole year before the Fed chose to move again. This year, however, it looks increasingly likely that we will see not one, or two, but three rate hikes. And as interest rates rise, there are implications for various asset classes.

In prepared remarks to Congress on Feb 14, Fed chair Janet Yellen said waiting too long to raise the federal funds rate would be “unwise” in the light of rising inflation and stronger economic growth. Jobs data has continued to improve, with the US adding 227,000 new jobs in January. That was more than the consensus expectation of 175,000. Domestic demand is also strengthening: Retail sales rose by a betterthan- expected 0.4% m-o-m. And consumer prices increased 0.6% m-o-m, the largest monthly gain since February 2013. The y-o-y gain of 2.5% was the biggest since March 2012.

Yellen also indicated in her testimony that the central bank does not have to wait for US President Donald Trump’s administration to outline plans for fiscal stimulus before raising rates again, further strengthening the prospect of a rate hike at the next Federal Open Market Committee meeting in March.

The prospect of higher interest rates has bond market investors racing for the exits. According to preliminary data from fund flow tracker EPFR Global, bond funds saw net outflows of US$16.9 billion ($24 billion) in 4Q2016. That was the biggest quarterly outflow since 4Q2015. Bond yields have trended downwards for three decades, with the prices of bonds moving inversely higher and making bond investors rich. In September 1987, the yield on the US Generic Government 10 Year index was 9.6%. It is currently 2.4%. Now, there are concerns that the bond bull market has run its course.

But Koh Liang Choon, who heads the fixed income team at Nikko Asset Management Asia, thinks calling this a bond bear market would be hasty. “The Fed has guided for three hikes in 2017, but it will be a very shallow and very gradual rate hike cycle. At that rate, it’s almost like one hike a quarter,” he says. Contrast that with Alan Greenspan’s fifth term as Fed chair, which saw 17 hikes over the course of two years. That is almost one rate hike a month,” says Koh. “Given the desynchronised recovery in the global economy, where we are still seeing uncertainty and political risks in Europe, and with Asia facing some slowdown as well, it is unlikely that the Fed will embark on a more aggressive rate hike cycle.”

Koh and his team of 14 portfolio managers and analysts are responsible for the various bond fund strategies that feed into Nikko’s bond funds. Among these is the flagship Nikko AM Shenton Income Fund, an absolute return fund that seeks to achieve returns in excess of 4% a year over the medium to long term. Launched in 1989 by DBS Asset Management, which Nikko acquired in 2011, it has returned an annualised 4.6% (net of fees) since its inception.

Koh says the team manages several dedicated fixed income strategies, including an Asia Credit Strategy and an Asia High Yield Bond Strategy (see charts and tables). Both strategies feed into the Shenton Income fund. Over the last three years, the Asia Credit Strategy has returned an annualised 6.1% and the Asia High Yield Bond Strategy, 8.4%.

Can the team keep up that performance in an environment of rising rates? How does it plan to adjust its strategies? And what future does it see for fixed income investing?

Better growth outlook
Former Fed chair Greenspan is best remembered for his easy money policies, an approach that introduced the term “Greenspan put” into the financial lexicon. The start of his first term in 1987 coincided with a stock market crash, which seemed to motivate the Fed to lower interest rates to promote liquidity and the flow of money into asset markets. The result was at least two decades of steady asset price inflation — equity, commodity and real estate prices soared. Incredibly, consumer prices trended lower during this period as globalisation — and China’s cheap labour — kept the cost of many goods down.

It was not until 2004 that Greenspan saw the need to raise interest rates aggressively. As interest rates rose, however, the large amounts of leverage that US consumers and corporates had accumulated became unwieldy. A resultant crisis caused Ben Bernanke, Greenspan’s replacement, to revert to the loose monetary policies of his predecessor.

Today, US inflation is still a relatively low 2.5%, but consumer prices look likely to rise as globalisation is knocked back by protectionist sentiment in parts of the developed world. And asset prices have rallied substantially in recent weeks on expectations of better economic growth. Yellen will not want to repeat Greenspan’s mistake and risk waiting too long to raise interest rates.

In fact, Koh believes the strengthening US economy warrants a gradual rate hike. “If you look at the US economic cycle, the economy has gained good traction. Trend growth is 2.5% to 2.6% and the labour situation has improved tremendously. On the labour front, clearly, it hits the Fed’s economic growth checkbox. On inflation, the trajectory is still towards their 2% target,” he says.

The recent rise in bond yields is “more of an adjustment than the end of a rally”, says Leong Wai Hoong, senior portfolio manager at Nikko. Leong, who is responsible for Nikko’s Asian credit portfolios, is bullish on US dollar- denominated Asian corporate debt. While higher interest rates and lower bond prices may cause some investors to rebalance their portfolios in favour of equities, Leong says demographics continue to support the demand for fixed income assets. Older investors typically prefer the security of a regular coupon and the high likelihood of getting all their capital back.

Importantly, strong fundamental growth in the Asian region has meant that default rates have been relatively lower — and recovery rates higher — for Asian credit. Since the Asian financial crisis of 1998, there has been no default in the Asian high-grade bond market. A January article by Nikko quotes figures from JP Morgan that put the Asian high-yield default rate at 0.9%. In comparison, emerging markets high-yield had a default rate of 3.5% and US high-yield had a default rate of 2.4%.

Leong sees no reason for default rates to rise this year. “Corporates generally do well in a high-growth environment,” he says. “The higher top-line revenue will cascade down, translating into better cash flow and an improvement in debt factors.” He also expects central banks to act in their own interests and the interests of borrowers. “Since the [global financial] crisis, the debt stock globally has increased, not reduced... [and] the cost of servicing debt is very high.” Any increase in bond yields would increase debt burdens. “We are recovering globally, but still not stabilised. We are in a very fragile place, and that’s one of the main reasons that the yield cannot go up too high. It will tilt the economy into a recession.”

Positive on Asian corporates
In fact, Koh believes it is time investors considered a dedicated allocation into the Asian fixed income space. “Asian fixed income has generally outperformed and contributed to stronger risk-adjusted returns compared with their global peers,” says Koh. In most asset allocation models, Asian bonds are lumped together with other emerging-market bonds.

The outsized Asian contribution to global GDP also makes a compelling argument for greater allocation into the region’s fixed income space, says Koh. China alone contributes 17% of global GDP, and Asia as a whole makes up about 50% of global GDP. “In spite of this, global allocation into the Asian fixed income space has been only about 5% in any of the global indices, which to us is a huge under-allocation,” says Koh. “And, despite a recent slowdown, Asia is still relatively stable compared with other regions.”

Unlike in the 1998 Asian financial crisis, Koh thinks there are currently no structural issues bedevilling Asian countries. “If you draw reference to the AFC, the main reason Asian currencies were under a lot of stress was primarily the overreliance on external liabilities,” he says. “If you look at Asia today, that has been very well managed. The majority of Asian issuers have learnt their lessons and have since hedged their liabilities.”

Leong also thinks investors have been underrating the Asian fixed income space. “Many people still have this misperception that Asian fixed income is a cowboy market. But that was how the market was 15 to 20 years ago during the Asian financial crisis. The Asian credit space has developed from about US$200 billion seven years ago to its current value of more than US$700 billion,” says Leong. “Why not position yourself earlier if you think the market is going to improve?”

Against this backdrop, Leong prefers Indonesian and Indian corporate debt in his Asia Credit portfolio. He likes the domestically driven sectors, particularly technology, utilities and telcos. Leong also likes infrastructure, citing the US, Indonesia, India and China as countries trying to drive domestic growth through infrastructure spending.

His preference is for high-grade rather than high-yield bonds. “On a risk-adjusted basis, high-grade bonds still offer high risk-adjusted returns,” Leong says. To boost returns, however, he has turned to short-duration, high-yield bonds. “Short-duration high-yield will buffer investors against a potential [higher interest rate] environment this year.”

China not a big concern
This year, Koh says, the US dollar can be expected to remain strong relative to Asian currencies, but he sees no huge gains from here. “We don’t expect to see outsized depreciations in any of the Asian countries, barring idiosyncratic risks,” he says. “The US administration realises, after the US dollar strengthened by 7% to 8%, that it is detrimental to their export competitiveness; hence the turnaround where Trump started talking down the US dollar. I don’t think it’s going to be a straight-line USD run-up.”

That leaves room for investors to take some risk on Asian currencies. In the local-currency- denominated bond space, senior portfolio manager Chia Woon Khien is focusing on high-yielding currencies. “We are at the start of the growth cycle, so we are still very much looking at opportunities for yield,” says Chia, who oversees Nikko’s Asia Local Rates and Currency Markets portfolio.

“Indonesia and India happen to pop out, where we still have a lot of pickup from the Indonesian and Indian rates if you are comfortable with the currency risks.” She expects the yields from Indonesian and Indian bonds to be enough to cushion investment returns from the impact of a strengthening US dollar.

Chia is also looking at markets that are more open and correlated to the US market. “Give the Fed one more hike, and Singapore and Korea are two markets where we can go in and look at opportunities for more duration plays,” she says. Currently, she is neutral on both markets, as their yields are relatively low. As markets price in higher interest rates over the longer term, however, the bond-yield curve is likely to steepen. This means yields for longterm bonds will rise relative to those for shortterm bonds. “When the curve starts to steepen up more, there could be opportunities for investing into the long-end duration,” she says.

Meanwhile, Chia sees a chance of the renminbi strengthening against the US dollar. While the market is concerned about the country’s indebtedness — at the corporate as well as government levels — she sees some positive momentum. For instance, the Chinese central government has been asking provincial governments to be more fiscally responsible in terms of tax collection and how they handle their revenue. There have also been attempts to reform state-owned enterprises (SOEs), which are major issuers of Chinese debt.

Chia expects the Chinese government to continue on its current path of liberalising the currency, easing capital controls and deleveraging its economy. “The extent to which they will succeed is contingent on how they manage the deleveraging of their debt. If they stabilise everything by the second half of the year, then we will see a stronger and more stable China, which will challenge US dollar strength,” she says.

Leong says the debt crisis perceived by the market is a result of the government’s massive stimulus programme during the global financial crisis. “It was a very broad-brush approach via the banks to basically pass out the cash to the corporates. In the end, those who borrowed from the banks were largely SOEs,” he says. “The debt situation in China is still very much within the government’s balance sheet.”

In a worst-case scenario, in which the government has to write off a large chunk of this debt, Leong thinks the situation will remain manageable. “Government debt is only about 17% of the whole debt system and the total debt is only 250% to 260% of China’s GDP, [which is nowhere near as high as it is] in other countries, such as Japan,” he says. “The government can simply write off the debt from the system, which is what it did in the early 2000s when it cleaned up the non-performing loans in the system. Although, this time round, we don’t think it will do so because then the moral hazard issue will continue.”

Chia thinks the current reforms present an opportunity for investors to enter the China bond market. “The idea of SOE reforms is to eventually privatise the SOEs,” she says. “With China having already signalled its intention to become an international player, this is the opportunity for private investors to come in.” She says there are plenty of opportunities in China’s fixed income space, pointing out that the fixed income market in the country is bigger than its equity market. “There are more than 3,000 bond issuers there,” she adds. “We don’t have to look at all of them. We just have to look at the top 30 and it’s enough for us to have a lot of opportunities to invest.”

This article appears in Issue 768 (Feb 27) of The Edge Singapore which is on sale now.