- Inflation in the US has reached its highest levels since February 1982. As pressure is mounting on the Fed to take a stronger stance against inflation, we believe it could turn more aggressive on rate hikes.
- Historically low interest rates and bond purchases have fuelled rapid growth in the global high yield bond market. The removal of this “safety blanket” could lead to an increase in defaults. Besides, covenant weakness is leaving investors exposed.
- We see room for spreads of global high yield bonds to widen further on the back of credit deterioration. The bond prices also seem to be understating the outlook on inflation and rate hikes, as yields remain compressed.
- Nonetheless, not all is doom and gloom in the fixed income space. Investors on the hunt for yield and diversification benefits can consider Asian high yield bonds, Chinese government bonds, unconstrained bond funds, and short duration bond funds.
Despite the Russia-Ukraine crisis injecting uncertainty into the global economic outlook, major central banks are likely to go ahead with a tightening of monetary policies. A US Federal Reserve rate hike spree is looming, with the first hike likely to come in this month. Meanwhile, the European Central Bank has opened the door to the possibility of a rate hike later this year.
However, even as investors brace for this policy shift, there looks to be much calmness in certain bond markets. The Bloomberg Global High Yield Index, a barometer for junk debt issued around the world, fell by only -7.7% year-to-date (as at 8 March 2022).
This is in stark contrast to the interest rate sensitive, tech-focused O’Shares Global Internet Giants Index and the Ark Innovation ETF (NYSE:ARKK), a widely followed product investing in high-growth unprofitable tech companies, which sank by -31.6% and -38.0% respectively during the same period.
Figure 1: The market has been kind to global high yield bonds
Does this mean that high yield bonds are less sensitive to a
monetary tightening?
We believe that all is not as it seems.
Time for the Fed to play catch-up
Inflation in the US has reached its highest levels since February 1982, with the January year-on-year consumer price index (CPI) print coming in hotter than expected at 7.5% (Figure 2). Moreover, the risks to inflation are skewed to the upside as the Russia-Ukraine crisis has been pushing up commodity prices.
Figure 2: US CPI since 1982
Coupled with near zero interest rates, the inflation levels – which has surged far above the target of 2% – may well suggest that the Fed is behind the inflation curve (i.e. not raising rates at a pace fast enough to keep up with inflation). Pressure is mounting on the Fed, who is still doing quantitative easing, to take a stronger stance against inflation. We believe that for the Fed to play catch-up, it could turn more aggressive on rate hikes.
(Related article: Seven rate hikes in 2022 an increasing possibility)
Markets are currently pricing in at least six rate hikes by the end of this year. However, we think that under an aggressive tightening scenario, there could be seven rate hikes of 25 basis points (bps) each this year. We also expect five additional hikes in 2023, which would bring the federal funds rate to 3.25%.
Such aggressive rate hikes, together with the end of quantitative easing (QE), would no doubt put a greater downward pressure on bond prices.
Writings on the wall for global high yield bonds
We are particularly cautious about global high yield bonds, as they are likely to face greater volatility from the end of QE as well as rate hikes. Geographically, global high yield bonds consist mainly of those issued in North America and Europe (Figure 3).
Figure 3: North America and Europe collectively make up 83% of global high yield bonds
Historically low interest rates and QE (otherwise known as bond purchases) were factors that helped fuel the rapid growth of the global high yield bond market. With investors embracing risks on their hunt for yield, the issuance of US and Europe high yield bonds over the past two years reached a record of approximately USD 870 billion and EUR 235 billion respectively.
Figure 4: High yield debt issuance over the past decade
However, when QE ends, borrowers will soon find themselves having to repay the debt or refinance it in a market that is no longer flooded with liquidity. The removal of this “safety blanket” could lead to an increase in defaults among high yield issuers.
Besides, the strong demand for high yield bonds has given borrowers the bargaining power to loosen borrowing terms. According to Moody’s North American Covenant Quality Indicator (CQI), which measures the degree of investor protection in high yield bonds, covenant quality score stood at 4.52 in the fourth quarter of 2021 (the higher the score, the weaker the investor protection, with the highest possible score being 5.0). This is below the historical average, and is also the second weakest level on record, demonstrating that covenant weakness is pervasive across borrowers.
Covenants set out certain activities that will or will not be undertaken by the issuer, and hence serve as protection for investors. Weaker covenants would leave investors exposed, which also suggests that recovery rates are likely to be lower in the event of a default.
Figure 5: Covenant quality of US high yield bonds has remained weak over the last three years
Valuations are unattractive
The spreads of global high yield bonds have widened, but they remain low based on historical standards. Current spread levels stand at 511 bps, which is below that of pre-pandemic levels as well as the historical average of 552 bps.
We see room for spreads to widen further as credit deteriorates under a monetary tightening environment. On top of that, today’s volatile operating environment driven by high inflation and a tight labour market, could spell the end of a conducive backdrop for high yield issuers.
Figure 6: Spreads are expensive based on historical standards
Moreover, we note that the prices of global high yield bonds seem to be understating the outlook on inflation and interest rate expectations, as yields remain compressed. Global high yield bonds are currently offering a yield-to-worst of 6.8%, or 219 bps below the historical average.
Figure 7: Yields tell a similar story
At a country level, US high yield bonds provide a yield-to-worst of 5.9% – below our inflation forecast of around 6% for 2022. Hence, the bonds provide yield-seeking investors little shelter from negative real yields in high quality segments such as treasuries and investment grade bonds. Similarly, European high yield bonds averaged a yield-to-worst of 4.7%, which is hovering near inflation forecasts.
Figure 8: Yields for high yield bonds are not that “high”
What’s next for fixed income investors?
While we see warning signs for global high yield bonds, not all is doom and gloom in the fixed income space. Here’s what investors on the hunt for yield and diversification benefits can consider –
(1) Asian high yield: We see Asian high yield bonds as a bright spot within the high yield segment. Embattled by tighter regulations, the liquidity crunch at Evergrande had sent ripples across the Chinese property sector, which accounts for over 20% of the Asian high yield bond market. The good news is that, with incremental policy easing in China paving way for the recovery of the property sector, credit concerns are likely to ease.
After the dramatic sell-off last year, we believe a large degree of credit risk has been priced in, providing investors with attractive risk-adjusted returns. Moreover, as bond prices have become so depressed, rising rates is unlikely to have a significant impact on Asian high yield bonds. We recommend investors to take an active approach, with the Eastspring Investments – Asian High Yield Bond ASDM SGD-H, in order to pick out quality names.
(2) Chinese government bonds: From a monetary policy perspective, China is in a different place as compared to the rest of the world. With weakening economic growth in face of multiple headwinds, China is likely to roll out more policy measures in order to stabilise the economy. The People’s Bank of China (PBOC) could continue easing in the first half of 2022, leading to more rate cuts which may bode well for the prices of Chinese government bonds. Our recommended product for investors is the ICBC CSOP FTSE Chinese Government Bond Index ETF (SGX:CYC).
(3) Unconstrained bond funds: Unconstrained bond funds differ from traditional bond funds as they exhibit higher flexibility with their asset choice decisions. Thus, unconstrained bond funds are able to better manage their interest rate risk during this challenging environment, serving as a complement to traditional bond funds in a well-diversified portfolio. Our recommended fund for investors is the Allianz Global Opportunistic Bond Cl AMg Dis USD.
(4) Short duration bond funds: Short duration bonds are less sensitive to changes in interest rates. The Nikko AM Shenton Short Term Bond SGD, LionGlobal Short Duration Bond Cl A Dis SGD, and United SGD Fund Cl A Acc SGD are attractive options for local investors to consider.
Related articles:
China’s 27%-yielding property bonds are set for a better year. Here's an ETF that can benefit.
Why it is still a good time to consider Chinese government bonds
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