bonds - why you need to be worried

4/28/2015 BondsWhyyouneedtobeworried

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20 April 2015

Market Update

Bonds Why you need to be worried

Executive Summary:Risks in the fixed income market have risen significantly following the 2008 financial crisis, asinvestors pour money into this asset class and companies of all types of financial standingissue debt at a prodigious rate. Investors must realize that not all bonds are the capitalprotected instrument they are made out to be. Banking regulations instituted after the crisiswill affect how bonds are traded and considered as a reserve requirement. Asset managersare increasingly worried about the liquidity profile and viability of their portfolios in a futurefinancial shock, and have been vigorously stresstesting their bond holdings. We are aware ofthe risks and are positioned defensively from an asset allocation perspective and guided byour risk matrix.

Article:IntroductionOver the past year, we have noticed an increasing number of reports about large assetmanagement groups stresstesting their bond portfolios. There have been concerns amongstbond managers over a potential lack of liquidity in the market caused by investor capitalflight and a bond selloff. This lack of liquidity is exacerbated by the Volcker rule, whichcomes into effect in July this year, placing restrictive capital requirements on banks andlimiting their proprietary trading divisions. This essentially removes banks from their role asmiddlemen in the bond market and reduces secondary liquidity quite significantly.

Bigger is Not BetterMany large fund managers have more than doubled the AUM in their bond funds since thefinancial crisis (Fig 1). The size of these large asset managers is currently under scrutiny by theUS Securities and Exchange Commission and Financial Stability Oversight Council, who areworried about the systemic risk these funds could pose should investors all head for the doorat the same time. The growth in fixed income investment was due to investors piling into theasset class, wrongly believing in its safehaven attributes after having been badly affected byequity performance since the financial crisis. In addition, many investors were hunting for yieldafter interest rates were driven to extremely low levels, thanks to QE. However, we have alsoseen a tremendous rise in corporate bond issuance over these past 5 years, as manycompanies took advantage of the large demand in bonds and low interest rates to refinanceand lever up (Fig 2).



Fig 1: The Largest Bond Funds in the World are More Than Double Their 2008 Size and ControlOver $1.3 Trillion in Assets

Fig 2: Phenomenal Rise in Credit Issuance and Growth of Fixed Income Investment Products

Concentration RiskLarge bond managers have cornered the high yield and emerging market bond market, withsome managers owning large chunks of certain bond issues (Fig 3): in effect acting like ashadow banking system to these below investmentgrade companies. With such a highconcentration risk, a run on the fund manager's assets could lead to serious implications bothin the financial markets and in the economy.



Fig 3: Large Funds Own More Than Half the Issuance in Some EM Bonds and More Than aQuarter in Some High Yield Issues

Liquidity RiskOn the surface, it may appear that there is still ample liquidity in bond funds as investors areable to buy and sell on a daily basis. However, this is just the top level flow liquidity, which isthe everyday flow of money going into and out of such instruments. The liquidity of theunderlying bonds itself has been declining over the years, with lower turnover and tradingvolumes being the most obvious sign (Fig 4). In addition, there is evidence that trade sizeshave also been declining, which implies a longer lead time needed to liquidate bondportfolios (Fig 5), especially those in the high yield and emerging market space up to 100trading days! In an extreme riskoff environment, this could be aggravated by daily liquidityfunds like ETFs and Unit Trusts. Investors who are early to the exit door may be able to get theirmoney back, but as more redemptions come in, the fund managers could prevent furtheroutflows as they are unable to sell the underlying assets.



Fig 4: The Growth of High Yield Assets is Outpacing Flow Liquidity. Couple This with DecliningTrade Volumes in EM Bonds

Fig 5: Declining Underlying Liquidity of the Bond Market

Volatility RiskFor those with investment knowledge and financial backgrounds, our textbooks taught usthat bonds typically help to temper volatility and provide diversification to portfolios whenthere is a market selloff (bonds rise when equities drop, and vice versa). The problem is thatinvestors have been led to believe that all types of bonds be it moneymarket paper orspeculative junk bonds exhibit the same characteristics. The truth is that the lower down thecredit spectrum you go, the more correlated bonds are to equity markets both in terms of riskand volatility (Fig 6). We see risks increasing within the lower grade space, with a realpossibility of defaults and receiving a big haircut on the original investment amount,especially when a large chunk of such bonds are due in 2017/18.



Fig 6: Rising Volatility and Increasingly Close Correlation Between Equity and Bonds

Interest Rate RisksWe have highlighted the risks to bonds during a normalisation of monetary policy in some ofour previous articles. Investors have become too accustomed to low interest rates for toolong since the crisis, and every delay in a rate hike creates a false sense of how long the partywill carry on. Make no mistake about it, rate hikes will eventually come, perhaps sooner ratherthan later, and it is best to be prepared for it. No matter what type of fixed income you hold,it is subject to interest rate risk, which affects the value of the bond directly (Fig 7).

Fig 7: Negative Price Movement on Different Types of Bonds Due to Interest Rate Risk

Investor ComplacencyHeightened bond fears in late 2014, following the collapse in oil prices, caused significantvolatility in bond markets and marktomarket losses for investors. However, data for the firsttwo months of 2015 showed that money has come back into the fixed income asset class (Fig8 and 9) despite risks remaining unchanged, especially with the Fed rate hike on the cardsand oil prices not finding a bottom just yet. Our concern is that investors could be blinded tothe dangers in the bond market in their chase for yield.



Fig 8. Inflows to All Bond Funds Topped US$17Bn, The Most Since Jan 2013



Fig 9. Inflows to High Yield Bond Funds Accounted for 30% of All Bond Inflows

Pricey and ExpensiveLooking across the board at major bond and equity markets, it is clear that bonds are pricedat extremes when compared to equity markets (Fig 10). From a risk/reward perspective, theupside that this expensive asset class provides is limited with asymmetric downside risk.Unfortunately, how much further overpriced and how long this phenomenon will go isanybody's guess. However, it is our view that we take a defensive position and be preparedfor when this happens.



Fig 10. Relatively 'Safe' Government Bonds are Priced to Perfection

The Bottom LineIt may appear that we are holding an extremely bearish view on fixed income. Please don'tget us wrong: fixed income still plays an important part in portfolio asset allocation. However,we are very aware of the risks that fixed income presents in today's situation, and we havebeen moving towards shorter duration and flexible sector bonds to guard against potentialdangers from this asset class. On top of this, we are quite certain that our overarching riskmatrix will enable us to derisk our portfolios including any risky bond funds in the event of afuture crash. This article is meant to warn all our investors on some of the possible hazards infixed income, especially after the immense surge in interest for this asset class following therecent financial crisis.

IMPORTANT NOTES: This report is provided for the information of the intended recipient only and should not bereproduced, published, circulated or disclosed to any other person without the prior written consent of GYC. Theinformation and opinions expressed herein reflect a judgment of the markets at its original date of publication and aresubject to change without notice. GYC does not warrant the accuracy, adequacy or completeness of the information



herein and expressly disclaims liability for any errors or omissions. The information is given on a general basis withoutobligation and on the understanding that any person acting upon or in reliance on it, does so entirely at his or her ownrisk. Any projections or other forwardlooking statements regarding future events or performance of countries, markets orcompanies are not necessarily indicative of, and may differ from, actual events or results. Neither is past performancenecessarily indicative of future performance. You should make your own assessment of the relevance, accuracy andadequacy of the information contained in the information provided and make such independent investigations as youmay consider necessary or appropriate. Accordingly, neither GYC nor any of our directors, employees orRepresentatives can accept any liability whatsoever for any loss, whether direct or indirect, or consequential loss, thatmay arise from the use of information or opinions provided.

GYC FINANCIAL ADVISORY PTE LTD 1 Raffles Place #1501 One Raffles Place, Singapore 048616 Tel: (65) 63491441 | Fax: (65) 63491440 | Email: [email protected] | Co Reg: 199806191K

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bonds - why you need to be worried

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