Bond managers are optimistic for their asset class but are watching central banks closely to see how they will manage inflation, finds Pete Carvill. Few people if any could have predicted the pandemic, but fewer still would have predicted the subsequent rate of recovery in capital markets. The general mood among the bond managers Funds Global Asia has spoken to is one of optimism about the near future. The feeling appears to be that as the pandemic subsides and people return to work in some of the most affected industries, the economy and markets will continue to improve gradually. Higher energy costs, fiscal stimulus and supply-chain shortages will soon wash through the system. The global bond market is considered incredibly robust. Anecdotally, the tailwind of the recovery is in Asia and the Middle East and North Africa (Mena) regions that have come back strongly. Oliver Kettlewell, head of fixed income at Mashreq Capital, says the Mena market has done well so far this year. “They’ve been pretty good at vaccinations in this part of the world and the stock market has responded positively. The bond markets are also doing well, particularly higher-risk bonds. The other factor is the oil price. Governments here rely on it to fund infrastructure. Even though it’s lower than it has been, it’s rallied substantially to nearly US$70 a barrel – up from below $50.” Other markets have a few more niggles in the system. In Asia, Arthur Lau, co-head of emerging markets fixed income at PineBridge Investments, says that the bond market is being held hostage by one firm at present – a reference to the state-backed China Huarong Asset Management Company, which has missed annual results deadlines and seen it bonds downgraded by Fitch from A to BBB. “Apart from that, the fixed income market in the Asian time zone has been doing well, especially compared to the developed world,” notes Lau. He is positive about the current state of the global bond market and the direction in which it is heading. “Of course, there are some pockets of turbulence because of the virus in India and Japan, but we don’t think that will derail the economic recovery, just delay it,” he says. “The situation is similar in Europe and, a few months ago, in the US. The general direction is onwards and upwards, but with some parts of the system being slower than others.” Meanwhile, opinion is divided on whether inflation will soon spiral. Some, such as Carsten Brzeski, chief economist at ING-Diba, say that inflation is inevitable. Parth Purohit, portfolio manager at Secor Asset Management, describes markets as “skittish”, in part due to the pick-up in inflation, which has seen a “substantial rise” from the various base effects. “As the global economy improves, we might see more of that,” he adds. Others think that the current bump in consumer prices is merely the base effects of the past year working their way out of the system. Whether higher inflation comes or not, the responsibility for what happens will lie with the central banks. Purohit says central banks have proved good at being accommodative in stressful market conditions: “The problem, though, is that it’s harder to know when to take your foot off the gas as the economy improves.” A doomed asset class?
So, what will happen with the returns from global bonds? The consensus is that returns will be positive but low. “Some investors think that the asset class is doomed from inflation and government borrowing,” says Kettlewell, “but bonds can deliver a positive return.” He adds: “Inflation is going to be persistent, and some are predicting high inflation, but that’s going too far.” Lau is similarly bullish about the Asian market, saying that the total return for Asian-dollar investment grade bonds should be 2% to 3%. However, he caveats that with the condition that this will be reached only if US Treasury bonds are at 2% at the end of the year. “From a duration standpoint, it’s going to be a bit tougher,” says Purohit. “I think a year from now, in Germany bonds are going to be above zero. I think you are going to get some negative returns from a duration standpoint.” While most of 2020 was spent dealing with the Covid-19 crisis, the thinking now is of what the future will bring. Purohit, who is based in the US, says that Secor was originally underweight in inflation against liabilities. That, he says, was lucky. “Since then, one of the biggest changes in the UK has been in hedging real yields. As the funding status has improved, we have been starting to de-risk clients, reallocating them from riskier assets into more hedging-type assets,” he says. Looking to Asia, Lau says that PineBridge Investments has been overweight in high yield bonds versus investment grade and local currencies. “The economic background right now favours high beta,” he says. “We’ve been overweight in high yield since late last year and we’re now looking to neutralise it all, given the volatility in interest at the beginning of 2021.” What about the Mena region?
“We’ve been buying more longer-dated government bonds,” says Kettlewell. “That’s because we’re not worried about inflation. If we are right, long-duration government bonds will do quite well as prices will rise and yields will fall. If we’re wrong and we do see out-of-control inflation, we could face short-term losses.” That said, Kettlewell is keen to point out one thing. “We do have balanced portfolios,” he says. “We have 30-year government bonds against one-year high yield corporate bonds. We also own a local property developer here that has a bond that will mature in a couple of years. At the end of the day, we don’t put all our eggs into one basket.” Clouds of concern
While inflation is a risk in 2021, there are other clouds on the horizon. One thing that Mashreq Capital’s staff is concerned about, says Kettlewell, is the possibility of new variants of coronavirus. The real fear is that a variant emerges that is resistant to the current raft of vaccinations, leading to a new wave of outbreaks, further lockdowns and a renewed vaccine race. Other worries include an unexpected move from the US Federal Reserve. “We look to them a lot to see what they’re doing. If they do something unexpected like increasing interest rates due to inflation, that would be a big risk for us as fixed income investors,” he says. Purohit takes a similar tack, saying that the biggest risk is inflation, but the central banks will do a good job of managing inflation if it does arise. The problem would be if there were a series of inflation surprises. “A lot of people have received a lot of money over the last year. They haven’t been commuting or going out so much, so they’ve been saving that money. There’s now a lot of pent-up savings that are being thrown into the equity market.” Desperate times often call for desperate measures. Last year, Carnival issued three bonds over the course of the year, secured against the value of its ships – an innovation aimed at gaining investor confidence. Azhar Hussain, head of global credit at Royal London Asset Management, says that while the Carnival bond looked somewhat bizarre, its fundamentals were quite solid. “The cruise line industry is in a bit of a unique spot. Compared to where Carnival was a year ago, they’ve been huge beneficiaries.” It was not such a bad idea, according to Hussain. “For most of these companies, they’ve now got less competition going into next year – the risk is something happens that knocks that out. That’s always hard to predict, but they’ve not got more than enough capital and liquidity to have zero revenues for another year.” Carnival’s bond, however, seems to be something of a one-off. “We’ve not seen anything like that here in the Mena region,” says Kettlewell. “A reason for that is that we don’t have a large range of issuers in Mena. The ones that do issue tend to be governments or somehow related to governments.” The future contains many unknowns, opinion is widely split and consensus is rare – but everyone will be watching closely, for sure. © 2021 funds global asia