Investors struggling with interest rate uncertainty

Bond allocators are in some disarray, after minutes from Wednesday's Federal Open Markets Committee meeting suggested one or two US rate rises may be on the cards this year.
Investors struggling with interest rate uncertainty

Conflicting expectations over divergence of monetary policy between the US and other countries are leading skittish investors to stick with short tenors and avoid moving down the credit-quality spectrum too much, heard a FinanceAsia conference yesterday.

Investors are struggling in light of pressure for US monetary tightening contrasted with pressure to loosen elsewhere, noted fund managers at the fifth Borrowers & Investors Forum for Southeast Asia in Singapore.

And Asia’s bond market is experiencing a new bout of uncertainty, courtesy of minutes from the Federal Open Markets Committee (FOMC) meeting released in the US on Wednesday. The minutes indicated that several committee members want to see US interest rates rise once or twice this year.

“If you believe you are in a low-rate environment, your investment strategy is clearer; you want to be in high yield, equities, more stable positions and add duration,” said Ronie Ganguly, portfolio manager at bond house Pimco.  

“The problem is with days like yesterday [Wednesday], when we end up not being sure if we are in a sustainable low-rate environment, as there is a multi-speed economy across the globe.”

More quantitative easing is planned in Japan, Europe and China, noted Ganguly, but the US has reached full employment levels and inflation is rising, pointing to the need for a rate hike.

Pimco was responding by trying not to go far down the value chain into very high-yielding credits at a time when liquidity is tight, he said. However, “this is challenging as we can’t sit on too much cash”.

The broad strategy acknowledged by all panelists was a simple one: be contrarian, and buy during volatility.

Gregor Carle, managing director in the alpha strategies investment group at BlackRock, said: “There isn’t much margin for error now, so we are focusing on names where we have higher conviction, but we have overall reduced risk over the last 16 months.”

He noted that fundamentals currently looked quite supportive of the debt market, with default levels being fairly benign. Yet this has offered its own challenges.

Carle pointed to significant net flows into Asia fixed income via exchange-traded funds since the start of the year, “as investors look to reach a yield target”. That flood of money has led yields to fall, which in some cases has meant Chinese property companies yield less than equivalent businesses in the US.

Arun Singhal, a portfolio manager at Millennium Asset Management, said much of today’s market uncertainties originated from drastic central bank actions. “We have seen rates and yields essentially go lower; from 15% in the US, rates have fallen to 160 to 170 basis points,” he said.

“Normally you’d think that is a bubble and it would correct, yet in Japan rates are negative, while in Germany they are 1% to 2%. Also, given demographics, everyone needs income on their savings that is getting smaller and smaller, so they are chasing more yield. That leads to a misallocation of capital.”

He cited US energy companies as an example, noting they could once raise debt with around 4% yield two years ago, only to struggle when crude oil prices dropped below $30 a barrel last year.

“To echo what Ronie said, when I feel like we have reached an extreme and there is too much euphoria in the market, then I try to short bonds,” Singhal said. “And when everyone is panicking, we try to pick names we are happy with, even in volatility.”

Investing opportunities
The panel was asked how best to invest amid the market uncertainty.

BlackRock’s Carle said it was not an easy issue. He noted that local-currency bonds have done well since the start of the year on expectations that the Federal Reserve would hold off from raising rates and thus from strengthening the dollar.

But Wednesday’s FOMC minutes have thrown that into confusion. “We had seen 5% returns [on local-currency bonds in Asia] since the beginning of the year, but that is probably tailing off now,” he said.

Ganguly said three main factors drove emerging-market credit performance: “The [US] Fed and the way it moves rates and impacts US dollars; secondly, oil prices; and thirdly China.”

However, he also noted that some $160 billion of EM debt has moved from investment to junk grade, following downgrades of Russia and Brazil. “The entire investment-grade pool has shrunk dramatically,” said Ganguly. "People looking to invest in emerging-market but not high-yield risk have less assets to chase.”

This is resulting in one principal beneficiary, he noted: Indian bonds. That “is one investment-grade credit where you know after 12 months it will still be investment grade. You can’t say that about many other markets.”

The panelists concluded by offering their views on China, the country’s debt burden and the impact that resolving it could have on the country.

Ganguly was relatively sanguine. “China has two options: reform and take the pain now, or kick the can down the road,” he said. “Most think they will kick the can down the road, but our view is more nuanced. We think they will kick it in periods of stress, but when conditions are settled, they will try to experiment.”

As a result, Ganguly said, the likelihood of a hard landing in the coming 12 to 18 months looks unlikely, meaning there are investment opportunities. Nevertheless, he remained highly cautious, warning investors to be watchful of “moral hazard trades”.  

Carle agreed, noting the country appeared prepared to see an ‘L’ rather than a ‘V’ economic recovery, with growth remaining around 6.5%.

“Lots of issues in China would worsen if economic growth ticked up again,” he noted. “So if they are fine with 6.5% growth, they can probably manage reforms. Now we are looking at it and wondering how much of their debt is good debt.” 

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