Year of the bonds

Hong Kong is obsessed withbig yields, but investors must diversify in 2013, says Jasper Moiseiwitsch

PUBLISHED : Monday, 31 December, 2012, 12:00am
UPDATED : Monday, 31 December, 2012, 4:58am

For all the gloom, some may overlook the fact that 2012 was a great year. Virtually all asset classes scored gains, with even equity markets venturing into positive territory thanks to a second-half rally.

But one asset ruled in 2012: bonds. Of the US$11.6 billion new money invested in funds in Hong Kong in 2012, US$11.2 billion went to bond and income funds, according to the Hong Kong Investment Funds Association (HKIFA). "Bond and income funds completely dominate mutual fund sales," says HKIFA chairman and Schroders Hong Kong head Lieven Debruyne (see graph).

Investors wary of share market volatility in the context of a weak global economy, and keen to get a little bit of yield an environment of near-zero deposit rates, are buying bonds. In particular, they are buying high-yield bonds, the best-selling fund category in Hong Kong in 2012 (based on data up to October), according to the HKIFA, with gross sales of US$9.8 billion.

"Everyone is going after yield," says Isabella Chan, the head of Hong Kong sales for Franklin Templeton, a fund house.  

So 2012 was the year of  yield. Hongkongers are piling into  debt, and that trend continued even after the Hang Seng Index began its rise in September, increasing 25 per cent since June. There has been a powerful trend in favour of bonds and it looks set to continue in 2013, according to  those in the industry.

But those looking to apply lessons from 2012 to their investment choices in 2013 might want to consider a few facts.

First, bonds are not the ultra-safe yield instrument some might believe. Bond prices have risen steadily over the past five years, but that doesn't mean they can't go down. Bill Gross,  the head of the world's biggest bond fund, Pimco,  has been very public about the spectre of interest-rate risk. He notes that interest rates will eventually rise. When they do, the event will knock back bond prices, even for the most highly rated debt instruments.

"Investors should understand that the double-digit growth in bond returns [seen in 2012], may come down. There are relatively high risks, such as of interest rates going up," says Bruno Lee,  regional head of retail sales for Fidelity,  a fund house.

Lee also worries that firms have been tempted by low interest rates to over-borrow, which could lead to defaults down the line, particularly among high-yield bond issuers. Indeed, mainland firms raised 14 times more money through the sale of bonds than of shares in 2012, according to Bloomberg, raising a record 4.1 trillion yuan (HK$5 trillion) in debt in the year.

Regulators are concerned in particular that local investors are too exposed to high-yield bonds. The Monetary Authority recently sent a questionnaire to private banks in Hong Kong that inquired about their sale of high-yield bonds.

The Securities and Futures Commission in November put out a circular that flagged a number of risks in high-yield bonds. The commission mostly stated the obvious: that high-yield bonds have a higher risk of default than investment-grade bonds (bonds rated BBB- or above). It also reminded the market that bond prices may go down if interest rates start moving up, and that high-yield bonds can be very difficult to sell during downturns.

The commission also flagged some of the unusual features of this investment, such as the ability of some issuers to force investors to accept payment in shares instead of cash, or to indefinitely extend the date for bond repayment.

Even more intriguingly, the commission shed light on the little-understood practice of fund managers  paying dividends out of capital invested. In other words, fund managers can take new money invested into funds and pay this out to existing investors as a dividend, giving the impression that the underlying bonds investments  generate higher  yield than actual.

Managers of high-yield bond funds pay dividends out of capital because they know investors are keenly focused on yield. The higher the yield, the more money a fund will attract. "A lot of the return is not only from yield but from capital gains," says Lee of Fidelity. "This contributes to an excellent performance in the asset class [high-yield bonds].

The downside  is that the payment undermines future returns of the fund, as the capital is not invested. In the meantime, investors may come to feel misled about a fund's real returns.

Mark Konyn, head of Cathay Conning Asset Management,  a fund house, says funds try to maintain a sweet spot in returns, aiming for at least  6 per cent to  8 per cent annual gains, and may dip into the fund's capital to get there. "Such practices are not allowed in other parts of the world," says Konyn.

A lesson for the new year

This year showed that Hong Kong investors have become very yield focused, but they have done so in that particular risk-seeking local style: people are diving into high-yield funds with a zeal that is making regulators nervous.

This has implications for 2013. While it is difficult to time markets, some specialists suggest  Hongkongers take their foot off the high-yield pedal and buy other assets, if only for the sake of creating a little diversity.

"Moving into 2013 … investors should add a bit more on equity exposure, perhaps first with balanced funds and then pure equity funds," says Chan.
Lee says investors could ease into equities by using dividends from bond funds to slowly buy shares.

Bonds still have plenty of supporters. Most expect the asset to generate respectable returns in 2013. "Fundamentally, bonds are not a super compelling story, but they are still a relatively compelling story," says Alex Boggis, Hong Kong head of Aberdeen Asset Management. 

But interest in equities has lagged far behind their returns in the second half and fund specialists  talk more about the risks of bonds.

Those wanting to get ahead of the next big investing trend might want to consider a little more  diversity and a little less high yield.