Why you should consider bonds amid earnings fears
With yields at attractive levels not seen in decades, there is no need to invest in riskier assets to chase returns
THE Silicon Valley Bank (SVB) debacle and mounting fears of a collapse of Credit Suisse last week left markets in shambles. Fears of financial instability resulting from higher interest rates created jitters over the prospect of a long recession, and caused a fall in investor confidence.
Equity markets have been volatile from the fallout of SVB. During this time, bond markets saw increased demand and outperformed equities, as investors poured into safe-haven assets in fear of a recession.
We think investing in fixed income will provide stable income amid market volatility, while providing diversification to one’s portfolio.
Stable income amid volatility
Bonds provide stable income even during market turmoil and volatility. Their coupons are usually paid on a semi-annual basis. Investors get predictable income streams which can aid in planning for cash flows in the future.
On top of that, the principal amount invested in a bond will be paid back on a bond’s maturity date (barring any default). The predictability of cash flows from bonds can guarantee returns amid volatile markets, where equities’ returns may not be favourable.
Diversification
Bonds provide diversification and mitigate downside risks to one’s portfolio. During a recession, bonds have traditionally outperformed equity. This is because it is less risky to hold bonds, which have a higher chance of recovery in the event a company is liquidated.
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Bonds also have a low correlation to other asset classes. This can help to reduce volatility in one’s portfolio, reducing further losses. As we tread through this period of market uncertainty, adding bonds now can help to shield some downside risk when a recession occurs.
Furthermore, with the yield curve inverted, investors do not need to invest in long-term bonds to get higher yields. At the time of writing, the two-year US Treasuries yield 3.98 per cent, while the two-year SGS bonds are yielding at 3.07 per cent. One can invest in these safer government bonds while not risking much opportunity cost in their investments.
Bond yields more attractive than equities
Right now, bond yields are at attractive levels not seen in decades, having surged as a result of the aggressive rate hikes by major central banks. Bond yields are looking much more attractive than earnings yields for global equities.
The spread is at its lowest point on record since 2009, and is now over two standard deviations below the 10-year average, suggesting that equities have become relatively more expensive than bonds.
At these levels, we think there is an opportunity for investors to take advantage of rising interest rates to lock in decent bond yields. This can generate regular income to help investors tide through the market volatility. There is no need to invest in riskier assets to chase returns.
Furthermore, it is our view that the global economy will sail towards a recession in 2023. The Federal Reserve’s tightening is already starting to bite, with leading economic indicators pointing to a slowdown.
A global recession is sure to provide headwinds for risk assets such as equities. Companies would see margins increasingly under pressure and experience slower earnings growth, paving the way for a moderation in equity returns due to a larger risk of negative price reactions.
With the restoration of relative attractiveness compared to equities, as well as the headwinds to risk assets, we urge investors to consider an overweight on fixed income.
Short duration, safer bonds
As the yield curve is inverted – short-term bond yields are higher than longer-term bond yields – we favour bonds with a shorter duration.
Investors can take advantage of higher short-term yields and earn attractive returns, while holding back on investing in equities as market volatility still persists. Rate hikes by the Fed will have a lower impact on the prices of short-duration bonds, as they are less sensitive to interest-rate risks.
We recommend that investors consider short-term government bonds such as US Treasury bonds or Singapore Government bonds (SIGBs).
The T 2.875% 31Oct2023 Govt (USD) bond currently has an indicative ask yield-to-maturity of 4.28 per cent, with around seven months to maturity.
Meanwhile, the SIGB 2.000% 01Feb2024 Govt (SGD) has an indicative ask yield-to-maturity of 3.58 per cent, with around 10 months to maturity. Although SIGBs have a lower yield as compared to their US counterparts, they are denominated in Singapore dollars, which makes them less susceptible to currency risks.
The writer is a senior research analyst of the Bondsupermart team at iFAST Financial Pte Ltd (IFPL), the Singapore subsidiary of iFAST Corporation Ltd. For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) has a position in T 2.875% 31Oct2023 Govt (USD). The analyst who produced this column holds a NIL position in these securities.
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