Inflation is said to be the bane of bonds. Inflation eats away at purchasing power, undermining the attractiveness of bonds as an instrument to deliver steady real returns. More often, bondholders face a double whammy as rates are raised by central banks as a tool to control inflation, which in turn impacts the nominal prices of bonds.
Market talk of higher inflation (and stagflation) has increasingly heated up recently. Seemingly, everything from housing prices and rental rates, car and pump prices, utilities bills to food prices are going up.
While higher inflation over the short term was already widely anticipated given the recovery of the global economy, expectations are increasing that inflation is not just transitory, with US 10-year breakeven rates (or implied inflation rate) rising to 2.59% as of Oct 29, which is near its highest levels since the Global Financial Crisis.
As of writing, our OCBC rates strategist expects the 10-year US Treasuries yield to increase from the current levels of around 1.5%–1.6% to 1.75% by end-2021, while yields of yesteryear which were below 1% have become a distant past.
Winter came early for Asiadollar while sunny Singapore did not escape entirely from the chills
Aside from the climb in rates, the Asiadollar market faced a multitude of challenges through October from uncertainty over the inflation trajectory to the onslaught of volatility from multiple credit negative developments among high-yield China property developers.
Investors also had to contend with downgrades of economic growth expectations in China from a slowing Chinese residential property market and acute power shortages leading to scaling back in manufacturing activities.
However, warmth did seep in towards month-end with investors tempering the potential fears over systemic risk. China’s sovereign credit default swaps retreated to 47 basis points (bps) on Oct 29 from an intra-month peak of 60bps while the sovereign successfully priced US$4 billion ($5.39 billion) of bonds in a multi-tranche deal with a strong order book reported at 5.8 times.
The effects of the rocky Asiadollar market did not spill over much to the SGD bond market, which served its relative safe-haven status, though primary markets initially turned quieter. However, there was little hiding in the secondary markets from inflation fears expounded in the US, especially as Singapore has little control over domestic interest rates.
See also: US bond market halts brutal run as buyers pounce on 4.5% yields
Market participants took a more defensive stance, shedding risk in the first few weeks of October with long-dated high-grade bonds and perpetuals with no legal maturity dates (and hence prima facie higher interest rate risk) taking the brunt.
By month-end, we observed prices stabilising and even partly recovering, with strong demand resurfacing for new perpetual issuances. As the SGD market had previously been trading tight, the consequent rise in yields may provide investment opportunities with certain subordinated perpetuals now trading at an ask yield to call in the high 3%–4% levels.
That said, issue structure remains a key consideration given that structure impacts the prospect of redemption at first call dates. A strong structure that encourages a call provides some mitigation over the risk of rising interest rates, though we advocate a perpetual-by-perpetual selection for this segment.
Heating the market without warming the planet
Amid the potentially challenging outlook for bonds, however, opportunities remain. With companies increasing their focus on Environmental, Social, and Governance issues and aligning themselves with numerous UN Sustainable Development Goals (SDG), this evolution has translated to the capital markets. Issuers are seeking innovative debt instruments to ink down their sustainability promises and commit their raised capital to either a specific use-of-proceeds or to reach an ambitious sustainability performance target (SPT) which is set at the issuer level. Consequently, this has led to the creation of the Green, Social, Sustainability, and Sustainability-linked (GSSSL) bond market.
In the SGD space, the GSSSL market, while still small as a proportion of total bonds issued, is fast growing. Issuers now range from quasi-sovereign entities such as the National Environmental Agency to educational bodies such as the National University of Singapore, REITs and corporates such as Ascendas REIT and Sembcorp Industries.
Recently, several issuers have leveraged on a relatively new bond instrument called a sustainability-linked bond (SLB), essentially a typical bond with an adjustment that links their SPTs to the issue structure of the bond.
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For example, Nanyang Technology University (NTU) recently priced its $650 million 15-year SLB which included a one-time payment of 50bps on the outstanding principal when the bond matures if it does not meet its SPT.
Interestingly, NTU’s bond stepup was structured in a way where the additional penalty does not go to investors, but rather into climate research investments, or to buy renewable energy certificates or carbon offsets.
In its bid to be a leader within its industry, Singapore Telecommunications also recently released its SLB Framework as part of the company’s commitment to reach its net-zero emissions target by 2050, the first for a telco in Asia Pacific.
Looking ahead, we expect the SLB market to expand in the coming years for three primary reasons. First, it represents a huge opportunity for firms beginning their sustainability journey or are in the transition phase to showcase their sustainability commitment to investors.
Next, companies refinance their existing plain vanilla bonds with GSSSL structures as this becomes the new “norm”.
Last but not least, increasing investor awareness and demand for GSSSL structures from both investment funds and high net worth individuals, possibly to also showcase their sustainability commitment.
Separately, a new structure has appeared in the EUR bond market combining different GSSSL structures, with Austria’s Verbund AG, an electricity producer, issuing a green SLB. Thus, we expect more innovation in this space as issuers look abroad for inspiration.
Banking on volatility
We also expect the market for bank capital instruments to remain active and provide opportunities. From a demand perspective, these structurally higher-yielding instruments should remain attractive to investors in a rising interest rate environment.
At the same time, we expect the supply of bank capital instruments to remain supported by the following three reasons.
First, ongoing refinancing needs to maintain minimum capital buffers; next, regulator interest to raise minimum requirements given the benefits of holding excess capital at the heights of the pandemic; and thirdly, likely higher capital requirements that will result from the implementation of climate stress tests as part of government climate risk actions tied to SDGs.
This is notwithstanding that financial institutions have exited the heights of the pandemic with robust capital positions. Their systemic importance and access to government financial and regulatory support enabled them to maintain financial system stability when it was needed most.
Combined with their solid market positions and diversified businesses, many have exited the pandemic with sound fundamentals and excess capital buffers that are either being returned to shareholders or are being kept as a buffer for possible inorganic growth and acquisitions or against any possible pandemic resurgence and residual uncertainty.
That said, uncertainty is not necessarily a bad thing for financial institutions, especially when it relates to economic and market uncertainty and volatility. In general, higher inflation is accompanied by market volatility – this creates opportunities for the trading businesses of Financial Institutions.
Higher rates as well create opportunities for financial institutions to improve their net interest margins as long as funding costs are managed amongst other things.
Low risk doesn’t pay for now
Despite the intra-month volatility, rates expectations had overall risen since September and this has not been kind to high-grade bullet bonds, particularly those on the least risky end of the spectrum and especially after a period of ultra-low interest rates and flush market liquidity.
The possibility of negative returns for high-grade bonds is high, especially as governments turn their attention towards tapering shortly.
As such, and in the context of a re-opening (albeit uneven) global economy, we are turning our preference towards high-yield credits on a highly selective basis. Current market dynamics should prevail in any selection as should evidence of stable and sufficient liquidity to meet ongoing obligations.
As an example, the global energy crisis and rising inflation environment is a positive for commodity-linked credits, many of which reside in the high-yield space owing to the cyclical and uncontrollable nature of their revenue streams.
That said, investing in commodities should also be considered in the context of rising environmental concerns and the ongoing focus on sustainability.
Andrew Wong; Ezien Hoo and Wong Hong Wei are credit research analysts at OCBC Bank’s global treasury research & strategy. Alvin Song is an intern with the team
Photo of NTU by Wengang Zhai on Unsplash
