Bond rally intact, but shift to high-yield debt and stocks, says Bank of Singapore

THE global fixed-income bubble is not at risk of bursting anytime soon despite the strong rally in bond prices this year. But investors will do well to trim their exposure to investment-grade bonds in favour of high-yield debt and look to buy equities if the world's major economies continue to show signs of improvement in 2013.

This is the advice Bank of Singapore has been giving its clients as investors mull the sustainability of bond prices in their quest for yield. "For 2013, we are looking at moving clients gradually away from investment-grade bonds into equities," Marc Van de Walle, 44, the private bank's global head of products, tells The Edge Singapore.

"Investment is never black or white. You don't sell everything in one asset class to buy just equities. It's just reducing your weight in investment-grade bonds and moving into equities," he says. "But before we do that, we want to see some signs that growth in the world is going to continue. If we see that confirmed — good numbers coming out from the US and China — then we will make the switch."

According to Bank of Singapore, a wholly owned unit of Oversea-Chinese Banking Corp, the search for yield by investors will intensify next year as the recovery in the global economy will be slow and interest rates remain low. "As interest rates go down, investors go into higher-yielding assets. Higher-yielding assets today are high-yield bonds and dividend-paying equities," says Van de Walle.

Bonds, even after the run-up in prices this year, are therefore not likely to face widespread selling pressure, with investors expected to retain their holdings to get regular coupon payments while using spare cash to buy stocks.

Still, the private bank sees limited upside for investment-grade bonds as valuations look stretched. Yields on US Treasuries, in particular, are at historical lows — the bank forecasts 10-year Treasuries to yield 1.5% to 2.0% next year — and better value can be found elsewhere.

"It's difficult to see very high quality bonds and Treasuries rallying," says Van de Walle. "Demand for investment-grade bonds has really been driven by interest rates. We don't see a lot of room for interest rates to go down and the yield curve is quite flat." He adds, however, that such bonds won't be "crashing" either since interest rates are not likely to rise substantially in the near term.

For better returns, Bank of Singapore advocates high-yield bonds, especially those of financially sound companies in emerging markets. Within the emerging-market high-yield space, it prefers B-rated bonds over those rated BB as valuations are more attractive.

In terms of geography, its favourite region for emerging markets in 2013 is Latin America, where high-yield bonds did not go up as much as those in Central and Eastern Europe as well as Asia this year. Economic growth in Brazil, Latin America's biggest country, is also seen to be stronger next year, backing the bank's bullish call on the region.

While the bank remains generally bullish on high-yield corporate debt, Van de Walle says bond investors should stick with companies with lower credit risks. "This is the mistake of a typical bond investor fixated with yields: You can get a 5% yield from a high-quality company. But once that bond comes to maturity, and the same type of company comes to offer 3%, you would tend to want 5% and so end up buying a bond with that yield but from another company with a higher credit risk. At the end of the cycle, you might hold only very risky companies. We tell people to be selective in going down the credit curve."

In that regard, demand for Singapore-dollar corporate bonds may continue to hold up, he says. "Singapore, like Switzerland, is considered a safe haven. This has an effect on the Singapore-dollar bond market. A lot of issuers have come to the market because investors are interested in holding the currency. At the same time, interest rates in the Singapore dollar are very low. This creates a very good environment for issuers of debt. They can finance themselves at a low cost."

Singapore-dollar bonds launched this year include ABN Amro's $1 billion 10-year issue, with an annual coupon of 4.7%, and United Overseas Bank's $1.2 billion 10-year programme, at 3.15%.

On the whole, Bank of Singapore forecasts returns of 9% to 10.5% for high-yield, emerging-market corporate bonds next year, down from the 18.6% return for the first 11 months of 2012. The lower projection is due in part to less compelling valuations after the run-up in bond prices this year.

Neutral on equities

On the equities front, the bank has a "neutral" call on the asset class, partly because stocks worldwide have gone up by at least 10% this year, although it may upgrade its call if global economic conditions strengthen in 2013.

In terms of region, it is "overweight" on China. "There is wage pressure in China but China is also a place where valuations are the most attractive [compared to the rest of Asia]," Van de Walle says. "The government there also has a lot of room to manoeuvre in terms of policy. They have a lot of money that they can put to work if the economy starts going down. They will make sure that the economy keeps improving."

Bank of Singapore's GDP forecast for China next year is growth of 8%, up from its 7.8% projection for 2012. "China's economy is affected by lower demand from the West, but it's not something that's dramatic. It's compensated by trade within emerging markets," he says. "Domestic consumption is also slightly edging up in China. They are also allowing wages to go up because they realise that people have to be rewarded for their work."

Given these conditions, he expects the Chinese market to "catch up" with Southeast Asian markets, where favourable domestic economic prospects have attracted significant flows of funds in recent years. He concedes, however, that the country still faces structural risks, which Beijing will not be able to address overnight.

"The Chinese leaders know perfectly well that they have to shift the economy. A pure export model is a thing of the past. They have to make sure they boost consumption, but you can't just switch the economy like that. This is something that's going to take years and years to do."

Underweight cash

With interest rates, especially in the US, poised to remain low for several years and inflation in some countries yet to abate, Bank of Singapore retains its "underweight" call on cash. "We tell our clients: 'You have to engage risks but do it in a prudent manner'," Van de Walle says.

While there is "an unusual amount" of tail risks, such as the potential for Europe's debt crisis to worsen and US economic growth falling short of expectations, he notes that these are "low-probability, high-impact" events. "Some people, because they fear these low-probability events, don't engage risks and so they stay in cash. But when you're in cash, you are certain to lose money."

Instead, those concerned about such events should buy "insurance", he says. "If you are really worried about the end of the world, buy put options, options on the S&P 500. If that event happens, you would be safe. That's the way to make money."

This story first appeared in The Edge Singapore weekly edition of Dec 24-31, 2012.

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