Emerging markets benefit

PUBLISHED : Monday, 28 November, 2011, 12:00am
UPDATED : Monday, 28 November, 2011, 12:00am

In a diversified portfolio, bonds are often seen as the 'unexciting' part - long-term holdings giving moderate returns. But with savings rates near zero and warnings coming from every side about the prospects for property, stocks and currencies, investors are seeing bonds in a new light.

The obvious attraction is the chance to actually earn some returns, rather than watch a hard-earned nest egg shrink at the mercy of market forces. The risk lies in the unprecedented nature of global uncertainties, which means - more than ever - that past performance is no guarantee for the future. As always the watchword is 'buyer beware'.

'We would advise against sovereign issues, particularly in Europe, and would instead focus upon the corporate sector in good quality companies,' says Andrew Williamson, head of advisory products, APAC, at UBS Wealth Management. 'Generally, we see developed market government bonds as expensive and barely expected to compensate for inflation over the medium term.'

The backdrop for this view is the expectation that economic growth will remain subpar, with central banks obliged to prolong their commitment to supportive monetary policies.

Given that, Williamson thinks that British and German government bonds will outperform United States Treasuries, the main reason being that the fiscal and monetary policy in Europe is more restrictive and the economic outlook weaker. To minimise risk, though, shorter-duration bonds are recommended.

Looking elsewhere, UBS believes that, in the longer term, emerging market (EM) bonds should benefit from their 'superior structural dynamics'. When one considers recent developments in countries like Greece and Italy, it is not difficult to understand why.

'Fund flows are an important short-term driver of this asset class,' Williamson says. 'And within EM, we prefer Asia over Latin America and Eastern Europe.'

Primarily, that is down to Asia's still strong fundamentals - export performance, lower debt loads, foreign exchange reserves - that compare favourably with other parts of the world.

Investors preferring a defensive strategy should therefore look at Asia-linked bonds issued by state-owned entities.

These should continue to offer attractive valuations and provide a way to diversify away from the US dollar. 'We see long-term attractive opportunities in renminbi- and Singapore dollar-denominated corporate issues,' Williamson says. 'And for bond investors who wish to take on more risk, we like the US high-yield market. Default rates remain relatively low by historic standards and we expect the sector to deliver superior returns over the next 12 months. However, it is important to understand that this sector displays a high correlation to equities and can therefore be volatile, so gaining exposure via a diversified fund is recommended.'

Stephen Corry, head of investment strategy, Asia-Pacific, at LGT Bank (Hong Kong), sees good value at present in investment grade and high-yield US corporate issues.

In contrast, he admits to being very wary of anything to do with the European sovereign bond market, pointing out that the ongoing accumulation of bad news is good reason to steer away.

Some people may still see German Bunds as a relative safe haven but, Corry notes, whichever way the European crisis plays out, Germany will ultimately be 'on the hook' for a very large bill.

'We see UK gilts as an alternative and, otherwise, our preference is for high-yield corporate or emerging market bonds,' he says. 'There are yields in excess of 9 per cent for some US corporate bonds, but [to invest in these areas], clients are probably better off buying a mutual fund, which offers a more diverse exposure. Then, if there is a corporate default, the impact is going to be minimal.'

Regarding the option of municipal - or muni - bonds, Corry suggests these generally have more immediate appeal among US-based investors. Tax exemptions contribute to this.

Anthony Michael, head of fixed income, Asia-Pacific, for Aberdeen Asset Management, believes that muni bonds can offer 'selective' value, but the firm's usual preference is for short-term government debt in Asia.

'Yields are 10 times what they are for US Treasuries and the governments are solvent,' Michael says. 'Asian and emerging market corporate debt - where spreads have widened recently - are also becoming attractive, but volatility is a deterrent and we would prefer to see things settle first.'

A further point to consider is the potential for underlying currency appreciation.

Michael notes that certain bond investors, typically those with a higher level of risk appetite and alternative sources of income, may take an opportunistic approach in the hope of making a killing.

'Banks are currently subject to increased regulatory restrictions and require more capital,' he says. 'The forced sale of assets may create opportunities for investors not faced with such challenges, particularly those with a longer-term horizon.'