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Wealth(February 2017)
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Good yield hunting

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Markets have done well since Donald Trump was elected US president. Yet tremendous uncertainty continues to loom over fiscal and monetary policies. In the past six years, we lived in a predictable world of slow and steady growth. Whenever growth faltered, central banks stepped in to limit any downside risks. However, monetary policies are reaching their limits.

With Mr Trump, fiscal policy and regulatory changes will take centre stage for 2017. At the heart of Mr Trump’s policy are two extremes. It is like an unstable pendulum. If he swings towards a fiscal thrust and deregulation, it is good for markets. But if he swings towards anti-trade, it will be bad for markets. This creates fatter tail economic outcomes, translating into higher uncertainty for asset returns. Indeed, it is a brave new world for investing.

Reflation a big theme for 2017
While Mr Trump’s policies are uncertain, what is more certain is that the US economy is operating at near full capacity and in recent months, economic activity has been picking up. Crucially, inflation is rising across the board. Furthermore, if Mr Trump’s fiscal policies are enacted, it will add more reflationary pressures on the global economy. Therefore, reflation is going to be a big theme for 2017. Inflation has big ramifications for bonds that pay out fixed coupons. In particular, higher inflation will erode the value of long-dated bonds. Hence, we prefer shorter-duration bonds that are less sensitive to rising inflation and rates.

Not all bad for high yield bonds
With an impending US fiscal spending spike and potential deregulation, the odds of a US recession for 2017 look less likely. Recession often coincides with higher default rates. This means that the potential rise in corporate default gets delayed.

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If Mr Trump pushes ahead with deregulation in the US oil sector, it will help US oil companies, especially those that have been struggling. Taken together, Mr Trump’s policies may not be bad for high-yielding bonds.

However, enacting big fiscal spending at a time when the US economy is close to full employment is precarious. Wage and inflationary pressures would be exacerbated if Mr Trump gets serious about the curbs on immigration. It is conceivable that the Fed would initially welcome higher inflation and tolerate an overshoot of the target for some time. Therefore, while rising rates may be a feature this year, the threat from rising default risk is going to be less problematic in 2017.

Leveraged loans: a good yield enhancer
In a situation of rising rates and higher inflation, the investment case for leveraged loans as another asset class for portfolio diversification looks compelling. The attractiveness of leveraged loans is that they keep pace with short-term rates, and hence do not expose the investor to capital risk in the event of a rise in interest rates at the long end of the maturity spectrum.

In fact, the coupon rates on the underlying instruments will reset periodically, leaving the investor with a gradually increasing income stream in a rising rate environment. In this way it actually hedges against rate risk, leaving the investor better off while conventional bonds are at risk of losing capital. Additionally, leveraged loans will do well should the default outlook remain benign for 2017.

Given the senior secured nature of the majority of the assets in this universe, the losses potentially suffered in the event of default are lower than with conventional bonds. The loan holder typically has a greater degree of protection than the unsecured bondholder and historically has had higher recovery rates than the bondholders.

EM bonds: an ideal place to search for yield
The rising US dollar and prospect of greater trade protectionism have increased risks for Emerging Market (EM) bonds. Yet some of this is in the price, with yields having shot up since the US election. Nevertheless, EM bonds still offer a big yield premium of more than 300 basis points over US Treasuries. The caveat is that investors have to brace themselves for lower EM bond returns in 2017. EM corporate bonds delivered a very solid 10.8 per cent total return in 2016, the best annual return for the asset class since 2012. This performance cannot be repeated in 2017. For this year, EM bond returns would come mainly from coupons.

The reality is that the outlook for EM has to be more nuanced. Differentiation within the EM asset class should persist, and the winners and losers will vary depending on how US monetary, trade and fiscal policies play out.

In the most benign scenario, if US fiscal policy expansion is combined with non-threatening trade policy and a dovish Fed, it would be the most analogous to the environment pre-election, with EM bonds performing well generally.

The more probable scenario is that the fiscal stance in the US becomes more stimulative and the Fed becomes modestly less accommodative, and the anti-trade stance is not as bad as most feared. In such a scenario, capital appreciation of EM bonds will be limited with its coupons as the main source of its returns. However, there will be greater differentiation; EM sovereign bonds which are less affected by global trade and with relatively strong external balances will be more resilient, while EM sovereign bonds with a bigger exposure to external trade and poorer economic fundamentals would probably be more vulnerable.

However, in a worst-case scenario, trade protectionism intersects with looser US fiscal policy and prompts the Fed to turn more hawkish with rapid response to counter the higher inflation. This would not be good for EM carry trade generally.

On bond regions, bonds from Central & Eastern Europe, Middle East and Africa (CEEMEA) could be shielded from Mr Trump’s policies.

In this brave new world of greater unpredictability, investors have to position defensively by reducing portfolio duration and going for higher-quality credit. EM bonds have had a good run in 2016 and investors have to be selective in their search for yield in 2017. Leveraged loans is a good portfolio diversifier and a yield enhancer for this year.


James Cheo is Investment Strategist, Bank of Singapore

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