20 April 2015

Market Update

Bonds - Why you need to be worried

Executive Summary:
Risks in the fixed income market have risen significantly following the 2008 financial crisis, as investors pour money into this asset class and companies of all types of financial standing issue debt at a prodigious rate. Investors must realize that not all bonds are the capital protected instrument they are made out to be. Banking regulations instituted after the crisis will affect how bonds are traded and considered as a reserve requirement. Asset managers are increasingly worried about the liquidity profile and viability of their portfolios in a future financial shock, and have been vigorously stress-testing their bond holdings. We are aware of the risks and are positioned defensively from an asset allocation perspective and guided by our risk matrix.

Over the past year, we have noticed an increasing number of reports about large asset management groups stress-testing their bond portfolios. There have been concerns amongst bond managers over a potential lack of liquidity in the market caused by investor capital flight and a bond sell-off. This lack of liquidity is exacerbated by the Volcker rule, which comes into effect in July this year, placing restrictive capital requirements on banks and limiting their proprietary trading divisions. This essentially removes banks from their role as middlemen in the bond market and reduces secondary liquidity quite significantly.

Bigger is Not Better
Many large fund managers have more than doubled the AUM in their bond funds since the financial crisis (Fig 1). The size of these large asset managers is currently under scrutiny by the US Securities and Exchange Commission and Financial Stability Oversight Council, who are worried about the systemic risk these funds could pose should investors all head for the door at the same time. The growth in fixed income investment was due to investors piling into the asset class, wrongly believing in its safe-haven attributes after having been badly affected by equity performance since the financial crisis. In addition, many investors were hunting for yield after interest rates were driven to extremely low levels, thanks to QE. However, we have also seen a tremendous rise in corporate bond issuance over these past 5 years, as many companies took advantage of the large demand in bonds and low interest rates to refinance and lever up (Fig 2).

Fig 1: The Largest Bond Funds in the World are More Than Double Their 2008 Size and Control Over $1.3 Trillion in Assets

Fig 2: Phenomenal Rise in Credit Issuance and Growth of Fixed Income Investment Products

Concentration Risk
Large bond managers have cornered the high yield and emerging market bond market, with some managers owning large chunks of certain bond issues (Fig 3): in effect acting like a shadow banking system to these below investment-grade companies. With such a high concentration risk, a run on the fund manager's assets could lead to serious implications both in the financial markets and in the economy.

Fig 3: Large Funds Own More Than Half the Issuance in Some EM Bonds and More Than a Quarter in Some High Yield Issues

Liquidity Risk
On the surface, it may appear that there is still ample liquidity in bond funds as investors are able to buy and sell on a daily basis. However, this is just the top level flow liquidity, which is the everyday flow of money going into and out of such instruments. The liquidity of the underlying bonds itself has been declining over the years, with lower turnover and trading volumes being the most obvious sign (Fig 4). In addition, there is evidence that trade sizes have also been declining, which implies a longer lead time needed to liquidate bond portfolios (Fig 5), especially those in the high yield and emerging market space - up to 100 trading days! In an extreme risk-off environment, this could be aggravated by daily liquidity funds like ETFs and Unit Trusts. Investors who are early to the exit door may be able to get their money back, but as more redemptions come in, the fund managers could prevent further outflows as they are unable to sell the underlying assets.

Fig 4: The Growth of High Yield Assets is Outpacing Flow Liquidity. Couple This with Declining Trade Volumes in EM Bonds

Fig 5: Declining Underlying Liquidity of the Bond Market

Volatility Risk
For those with investment knowledge and financial backgrounds, our textbooks taught us that bonds typically help to temper volatility and provide diversification to portfolios when there is a market sell-off (bonds rise when equities drop, and vice versa). The problem is that investors have been led to believe that all types of bonds - be it money-market paper or speculative junk bonds - exhibit the same characteristics. The truth is that the lower down the credit spectrum you go, the more correlated bonds are to equity markets both in terms of risk and volatility (Fig 6). We see risks increasing within the lower grade space, with a real possibility of defaults and receiving a big haircut on the original investment amount, especially when a large chunk of such bonds are due in 2017/18.

Fig 6: Rising Volatility and Increasingly Close Correlation Between Equity and Bonds

Interest Rate Risks
We have highlighted the risks to bonds during a normalisation of monetary policy in some of our previous articles. Investors have become too accustomed to low interest rates for too long since the crisis, and every delay in a rate hike creates a false sense of how long the party will carry on. Make no mistake about it, rate hikes will eventually come, perhaps sooner rather than later, and it is best to be prepared for it. No matter what type of fixed income you hold, it is subject to interest rate risk, which affects the value of the bond directly (Fig 7).

Fig 7: Negative Price Movement on Different Types of Bonds Due to Interest Rate Risk

Investor Complacency
Heightened bond fears in late 2014, following the collapse in oil prices, caused significant volatility in bond markets and mark-to-market losses for investors. However, data for the first two months of 2015 showed that money has come back into the fixed income asset class (Fig 8 and 9) despite risks remaining unchanged, especially with the Fed rate hike on the cards and oil prices not finding a bottom just yet. Our concern is that investors could be blinded to the dangers in the bond market in their chase for yield.

Fig 8. Inflows to All Bond Funds Topped US$17Bn, The Most Since Jan 2013

Fig 9. Inflows to High Yield Bond Funds Accounted for 30% of All Bond Inflows

Pricey and Expensive
Looking across the board at major bond and equity markets, it is clear that bonds are priced at extremes when compared to equity markets (Fig 10). From a risk/reward perspective, the upside that this expensive asset class provides is limited with asymmetric downside risk. Unfortunately, how much further overpriced and how long this phenomenon will go is anybody's guess. However, it is our view that we take a defensive position and be prepared for when this happens.

Fig 10. Relatively 'Safe' Government Bonds are Priced to Perfection

The Bottom Line
It may appear that we are holding an extremely bearish view on fixed income. Please don't get us wrong: fixed income still plays an important part in portfolio asset allocation. However, we are very aware of the risks that fixed income presents in today's situation, and we have been moving towards shorter duration and flexible sector bonds to guard against potential dangers from this asset class. On top of this, we are quite certain that our over-arching risk matrix will enable us to de-risk our portfolios - including any risky bond funds - in the event of a future crash. This article is meant to warn all our investors on some of the possible hazards in fixed income, especially after the immense surge in interest for this asset class following the recent financial crisis.

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