Bond watch

PUBLISHED : Sunday, 28 September, 2008, 12:00am
UPDATED : Sunday, 28 September, 2008, 12:00am

Investors will have many options to choose from, but analysts urge caution

Bond investors may be spoilt for choice in the final quarter of this year as many new issuers come to the market to raise fresh capital or roll over expensive short-term debt into longer-term paper.

But in the volatile market investors should proceed with more than usual caution, analysts warned. And the yield-enhancing bonds of emerging market issuers that have so far been in favour among Asian investors could be jettisoned as portfolios are rebalanced.

Much of the new paper due to be issued will be from banks. And, in a recent report, the IMF noted that banks around the world were 'currently adjusting the structure of their funding in response to the global financial turmoil by increasing liquidity and lengthening the maturity of their funding'. But in the present volatile market, this process had also thrown into sharper focus the rollover risks associated with banks' short-term debt. Fixed-income investors faced a delicate balancing act when repositioning their portfolios, said Norman Villamin, head of research and strategy investments (Asia-Pacific), at Citi Global Wealth Management.

'As of September 19, Moody's triple-A bond spreads were trading on a very wide spread of around 200 basis points above US 10-year debt, while BAA corporate bonds were trading at spreads of up to 370 basis points above treasuries. These are levels we last witnessed at the peak of the corporate debt scandals during the bursting of the technology bubble in 2001-02 and then during the US recession of 1980-82.

'What this is telling us is that the market is asking to be paid a substantial premium for the increased risk of default by borrowers. And in an environment where there is a large amount of debt to be rolled over, this may preclude some people from being able to roll over that debt,' he said.

In this respect the bond market had found itself in the same situation as equity markets where investors were uneasy that banks would fail in their bids to raise new equity with damaging consequences for their share prices. The new bond issues present investors with a chance to enhance the returns on their bond portfolios, but it also raises concerns that some borrowers might fail to raise fresh capital.

'In the fixed-income space, while we are aware that many Asian investors like emerging market corporate debt, we are of the view that the risk-reward landscape favours high-grade corporate debt given the historically wide spreads,' Mr Villamin said.

But, with the economic fundamentals in many emerging markets now coming under pressure, it was questionable whether the tighter spreads on offer in emerging market corporate debt offered sufficient compensation to investors willing to risk further fundamental deterioration, he said.

'For investors focused on the government bond space, we believe government yields are currently unattractive and prefer focusing on the prospect of yield curve steepening in Europe in 2009.'

Against this backdrop bond investors should be unusually diligent about studying the ratings and commentaries of credit agencies and closely examine the leverage and cash flows of corporate debt issuers, advised Chew Soon Gek, CIO Asia for Deutsche Bank Private Wealth Management.

Risk could also be managed by swapping fixed-rate paper to floating rates and portfolios could be 'laddered' by stepped maturity dates on the paper, Mr Chew said.

'Bond investors should also make their credit selection with an eye on diversification according to the desired credit quality of the portfolio, and credit protection can also be bought or sold via credit default swaps. In times of market dislocation, liquidity concerns become heightened, so a holding of liquid and highly rated short-term government bonds helps in capital preservation and meeting liquidity requirements.'