Are bonds overvalued?
Our love affair with bonds grows more intense by the day. From investment grade conglomerates in Hong Kong to high-yield energy companies in Kazakhstan, our appetite for credit risk - apparently - is unconditional and indiscriminate. We love them so much, there's not enough to go around. For every dollar issued, there's an average eight dollars of demand.
Asian US dollar-denominated bonds have returned an attractive 12 per cent year to date and there's nothing wrong with that. The only disappointment investors experience comes with the call from their bankers to explain why - in percentage terms - their allocations have often been scaled back to mid-single digits.
The problem with being love-struck is becoming blind to warning signs. And the most obvious question is whether Asian US dollar-denominated bonds are rich or still offer value. Are we in the lowly foothills of a bond bubble or are we about to hit the peak? Should investors hold firm or should they rotate, for example, into equities?
Average bond yields are at historic low levels. In fact, they've never been lower; between 1997 and 2011, the average yield of the HSBC Asian USD Bond Index (ADBI) stood at 6.80 per cent; as of today that yield has halved and now measures 3.40 per cent.
Some believe such low yields fail to adequately compensate investors for the risks they are taking. They believe the asset class has become so crowded, so over-bought, that the sheer weight of liquidity has crushed yields to such "artificially" low levels.
There may be some truth to such a view, but there's more to it. Asian bond yields are at all time record lows for fundamental reasons, reflective of continuing turmoil in our post-global financial crisis world. That's not just true of Asia yields but - excluding the peripheral economies of Europe - pretty much everywhere.
The challenges facing the global economy aren't receding; dangers posed by the fiscal cliff in the US should not be underestimated; a disorderly Greek exit from the euro zone remains a distinct possibility; and as latest German industrial production numbers show, Europe's recession is worsening and spreading north. China's economy may have bottomed - the jury's still out - but its subsequent near-term growth trajectory will more likely be U-shaped than V-shaped. Can you imagine a central bank raising rates in such an environment?
In fact, concern over the creditworthiness of the global economy is precisely why credit spreads (difference in yield between different securities) also remain at such elevated levels. For example, from 1997 to 2011, the average spread of the ADBI measured 280 basis points (100 basis points equals a 1 per cent change), not much wider than the current 270bps spread; and considerably wider than the all-time tight print of 72bps in July 2007. In other words, wider spreads are likely to endure - for as long as global risk remains elevated - which suggests that, rather than the capital appreciation of 2012, investing in Asia's (especially high yield) bonds in 2013 will become much more a coupon-clipping or carry trade.
So hang on to your bonds for now as we do not believe there is a bubble. By all means rotate into equities when the global economy has repaired, when earnings growth has turned positive, and confidence has returned such that the US dollar starts to materially weaken. But until then credit continues to offer attractive risk-adjusted returns. Learn to love your bonds, but be selective and don't rush after the first offer that comes along.