While mulling the increasing distance between yields on the 10-year US treasuries (US risk-free rate) and yields on 10-year Singapore Government Securities (local risk-free rates), some market watchers point to the interest rate parity (IRP) concept to explain this difference.
IRP is the equation that governs the relationship between interest rates and currency exchange rates. Its basic premise is that hedged returns from investing in different currencies should be the same, regardless of their interest rates. Therefore, if local investors buy US dollars to get a higher US risk-free return, investors would also have to hedge that exposure as a risk mitigant.
According to Investopedia, IRP is the concept of no-arbitrage in the foreign exchange markets (the simultaneous purchase and sale of an asset to profit from a difference in the price). That is, investors cannot lock in the current exchange rate in one currency for a lower price and then purchase another currency from a country offering a higher interest rate for gain. Some analysts believe that at some point, these two diverging risk-free rates could converge.
Sovereign ratings
Interestingly, in a paper by the Bank of International Settlements (BIS) some years ago, when researching factors determining Asia Pacific bond yields, its authors Mikhail Chernov, Drew Creal and Peter Hördahl pointed out two natural drivers of bond yields were credit and currency risks, which they labelled as the Twin Cs. “A changing likelihood of sovereign default is likely to affect the exchange rate. A weakening exchange rate could be a precursor of fiscal stress and higher credit risk,” the authors said. They labelled debt and default as the Twin Ds. So far, no notable sovereign Asia Pacific economy has defaulted, though defaults among Chinese property developers are aplenty.
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Then as now, the BIS said Singapore is an exception “as we consider Singaporean bonds as credit risk-free due to their AAA status”. This may well be one of the reasons that local risk-free rates remain a lot lower than other risk-free rates in the region as well as US risk-free rates.
According to the BIS paper, Asia Pacific bond yields are driven by both local and global macro and yield factors. Among local factors, domestic inflation is important with higher inflation implying a higher interest rate. The other factor is credit ratings.
In recent weeks, political deadlock has once again affected the US Congress. According to CNN, Republican House Speaker Kevin McCarthy privately delivered a message to Senate Republican Leader Mitch McConnell that the Senate’s bipartisan bill to keep the government open would not get a vote in the House of Representatives unless significant changes are made. The impasse may cause a shutdown on Sept 30.
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In addition to a higher credit rating, only nine countries — Australia, Denmark, Germany, Luxembourg, Netherlands, Norway, Singapore, Sweden and Switzerland — have AAA credit ratings from Fitch, Moody’s and S&P. A rough rule of thumb is that high credit ratings give a company or government access to capital at lower interest rates.
While Euribor is often used as a benchmark for European debt, the 10-year ECB government bond yield is at 3.34%, a lot closer to Singapore’s risk-free rate than the US.
Outlook and impact
Despite lower risk-free rates in Singapore and Europe, the direction of risk-free rates in developed markets is upwards. Market watchers expect US risk-free rates to rise to as high as 5%. In addition, the gap between two-year and 10-year yields of US treasuries has narrowed swiftly as investors change their minds about a recession.
DBS Group Research research says the outlook of higher for longer, and a narrowing of the 10-year and two-year yield spread impacts some S-REITs negatively. “Our interest rate strategist notes the current bear steepening of the US yield curve (ie. long-term interest rates rising faster than short-term rates with the 10-year yield starting to price in a robust US economy) has yet to show signs of abating or capitulation.”
REITs with a yield spread of less than 200 bps versus 10-year SGS yield may face downside pressure, especially if risk-free rates stay high or move higher, according to the research note.
“Stocks most affected are ParkwayLife REIT, Keppel DC REIT, Mapletree Logistics Trust M44U and Frasers Hospitality Trust ACV . While these stocks have favourable operational metrics, the tightening yield spread of more than 200 bps will nevertheless be a dampener to the stock price in the near-term,” DBS says.
