Glimmer Of Hope For Bonds?
In a difficult global bond environment, find out how fund managers are positioning their funds to enhance returns.
by Jean Paul Wong
With the recent volatility in global equity markets, has there been a flight to other asset classes such as bonds? The increase in risk aversion among investors exposed to global emerging markets has been sharp. In a recent Dow Jones report, Merrill Lynch said that net outflows from emerging stock markets amounted to US$13.41 billion over the four weeks since 17 May 2006. Prior to the sell-off, from the start of the year to 17 May 2006, net inflows to emerging stock markets reached US$32.87 billion, compared to US$10.39 billion for the net inflows of stock markets globally. While the risk appetite of investors has apparently been on the wane in recent weeks, it would be wrong to extrapolate that the outlook for bonds is positive because of the recent volatility in equities. Over the past one year, the environment for global bonds has been challenging, and this has been reflected in the performance of the bond funds. In a situation where inflation continues to be a concern for major central banks across the world, rising interest rates look set to continue. And this would continue to be a negative development for bonds generally, as there is an inverse relationship between interest rates and bond prices: as interest rates rise, bond prices fall, and vice-versa. In an interview with the fund manager of the Lion Capital Global Bond Fund, Chang Kang Yee, and with the global fixed income team at Franklin Templeton, they explain their views on the global bond market going forward. RISING INTEREST RATES Although interest rates in the US are expected to peak, after rising from 1% in June 2004 to 5.25% in early June 2006, recent comments from the US Federal Reserve suggest otherwise as fears over inflation persist. Interest rates in the Eurozone are also expected to continue increasing (after rising to 2.75% in June 2006). In Japan, the Bank of Japan is expected to finally increase interest rates. In a June 2006 note on the outlook for global fixed income, Franklin Templeton says that markets have become especially concerned about the potential for higher inflation – stemming partly from higher commodity prices but also from strong global demand – to push interest rates up further than expected and slow growth. But Franklin Templeton says that the recent concerns have been “exaggerated”. The fund house notes that the Fed’s preferred measure of inflation, namely the core personal consumption expenditures or PCE index, recorded an annualized growth rate of 2.1% in April. And although this is higher than the Fed’s stated comfort zone of 1-2%, it is “hardly enough to justify a major crisis on world markets, and not much higher than the levels registered in several months last year or even earlier this year”, says Franklin Templeton. While Lion Capital’s Chang agrees that interest rates are expected to go up going forward, “they are not likely to push deep into restrictive territory, barring further upside surprises on inflation”. Nevertheless, at the moment, the Lion Capital Global Bond Fund is defensive on interest rate positions in view of the risk of further rate hikes. However, Mr Chang adds that “bond yields are expected to plateau as we move closer to the end of US monetary tightening cycle on the prospects that growth momentum is likely to decelerate in 2007 and recent pick-up in inflation prove temporary.” Thus, the fund is aiming to progressively lengthen the portfolio’s duration as bond yields move higher. BETTING ON CURRENCIES For Singaporean investors who have a SGD-denominated portfolio, any currency fluctuations in their investments would have repercussions on returns. In the case of bonds, this would be especially important, as returns may be wiped out if the SGD appreciates against the currencies the fund invests into. Lion Capital’s Chang agrees, and has therefore limited the fund’s foreign currency exposure to less than half of the value of the fund. For USD-denominated positions which are unhedged, the fund’s exposure is mainly concentrated into Asian credits. Mr Chang explains: “Asian credits constitute most of the fund’s exposure to unhedged USD-denominated bonds. As we have witnessed recently, the USD currency could benefit from a rise in global risk aversion. We would thus maintain the USD currency exposure associated with these positions in the near term as a hedge against another potential round of global risk reduction”. At times when investor risk appetite falls, as we’ve seen recently, there is a tendency for monies to move from riskier asset classes (such as emerging market equities) to so-called safer havens (such as US Treasuries). In such a situation, the USD would likely appreciate. Close to half of the fund’s currency exposure is to the SGD. Mr Chang says that the SGD has been taken by some global investors as a proxy for their positive view on Asian currencies in general, and would therefore have a positive impact on the SGD. Furthermore, the fund manager notes that in its latest monetary policy statement, the Monetary Authority of Singapore (MAS) maintains the current modest and gradual appreciation of the trade-weighted currency, and a strengthening SGD currency is expected to help dampen the upward pressure on local money market rates and provide support to the domestic bond market. Based on the fund’s fact sheet (as at May 2006), the fund had 49.1% in Singapore in terms of country allocation. Other Asian currencies the fund has recently added include a small exposure to Malaysian ringgit bonds (5.5% of the fund as at May 2006). Franklin Templeton also notes that the development of Asia’s own bond markets is increasingly being seen by countries as an alternative way to channel surplus reserves back into the region. The fund house adds that Asian countries, which have amassed some US$2.73 trillion of foreign exchange reserves, much of which is invested in US Treasuries, would likely invest more into their own bond markets. In such a case, the USD would come under increasing pressure to decline. Franklin Templeton says that Asian surplus funds make up over one-third of US current account deficit. So far this year (as at 27 June 2006), the USD has fallen by 5.7% against the Euro, and 4% against the SGD. But Franklin Templeton observes that while the prospect of higher Eurozone interest rates have pushed the Euro higher, this would not likely persist as the European Central Bank (ECB) looks less eager to return to a more neutral footing rapidly – as such, the Euro is expected to tread water for the time being. RISK & OUTLOOK Lion Capital’s Chang says that the Lion Capital Global Bond Fund would adopt a defensive stance on interest rates in the near term, but it would progressively lengthen duration as bond yields move higher. Franklin Templeton notes that it does not believe the recent yield curve inversion has been sufficiently dramatic to signal a warning on the direction of the US economy or a serious inflation scare. A likely cooling US growth in the months ahead should relieve price pressures and lessen the burden on the Fed to increase rates. Mr Chang says that the fund “also aims to enhance the return through investment in corporate bonds. We are neutral on credits due to tight credit spreads and marginal deterioration in credit quality taking place as a result of corporate merger and acquisition activities. Nevertheless, the broad fundamental drivers of credit quality remain healthy amid modest supply. We would focus on bonds with stable credit fundamentals, and that offer attractive yield pick-up over government bonds”. Further upside surprises on inflation would be a major risk factor for the financial market, adds Mr Chang, and this could pressure central banks into pushing monetary policy deep into restrictive zone and trigger further risk reduction by investors as global liquidity cycle continues to tighten. FUND PERFORMANCE COMPARISON Global Bond Funds 1 yr 2 yr 3 yr 4 yr 5 yr 10 yr Since inception -8.5 -2.3 -1.7 3.2 3.1 - - -1.2 4.9 3.0 6.9 6.6 - - -2.3 3.4 - - - - - -9.1 -2.3 -1.5 2.9 - - - -6.8 0.1 0.1 4.2 4.2 - - -3.7 -0.2 0.4 4.1 4.3 4.6 - -9.3 -2.8 - - - - - - - - - - - -5.7 -6.8 -3.2 -1.8 1.5 2.4 - - -8.4 -1.8 -1.1 3.6 3.5 - - -3.1 2.2 1.0 3.0 4.0 1.6 - Source: Fundsupermart.com; prices as of end-May 2006. The performance figures in the table above are calculated using offer-to-bid prices, with any income or dividends reinvested. Performance figures of over 1 year are annualised. (E.g. A 33.1% gain in 3 years works out to a 10% gain per year when annualised.) As per MAS regulations, the offer price is based on the normal sales charge which is higher than Fundsupermart's discounted sales charge. As mentioned earlier, bond funds have been experiencing a difficult environment in the past one year. The average return over the last one year was -6.3% (on an offer-to-bid basis). Funds which adopt an absolute return approach (meaning that they do not have to track the benchmark) have fared better generally. These funds include the DBS Shenton Income Fund (down 1.2% over the last one year), Franklin Templeton Global Bond Fund (down 2.3%), and Lion Capital Global Bond (down 3.7%). Over a longer time horizon (2 years to 5 years), the annualized return of most funds is in positive territory. The geographical breakdown for the two funds is as follows: Franklin Templeton Global Bond (as at 31 May 2006): Lion Capital Global Bond (as at 31 May 2006): Where Does This Fund Belong In An Investment Portfolio? Both the Lion Capital Global Bond Fund and Franklin Templeton Global Bond Fund are in our Fundsupermart Recommended list (click here to view our list of recommended funds), and can be part of a core portfolio for the long term investor. That's because global bond funds are considered low risk (with a Fundsupermart risk rating of 2; click here to view our risk rating system) and have lower volatility than equity funds. Thus they provide much needed stability through various market conditions. Although bond markets can go through cycles, the fluctuation of bond funds is much lower when compared to equity funds. Historically, bond funds seldom go through years when the overall return is negative. Most times global bond funds can provide a consistent positive return, although this may be significantly lower than what an equity fund can achieve in a rising market. The pie chart above illustrates where global bond funds belong in an overall portfolio (click here to find out how to start a portfolio from scratch). The percentage which should be allocated to global bond funds is dependent on an individual's risk profile. The diagram below shows the asset allocation for a balanced investor, and may not reflect an individual's risk/return profile. (To view investment portfolios tailored for different risk profiles, click here for our Fundsupermart Recommended portfolios).
