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Fixed maturity products lose lustre as rates rise

Fixed maturity products lose lustre as rates rise

When Jerome Powell made his first public statements as chairman of the US Federal Reserve in February, markets were watching to see whether a dove or a hawk would be leading them through the next four years.

What they got was the same broad policy direction as Powell’s predecessor Janet Yellen, but his comments to the US House of Representatives committee on the growing strength of the economy made observers nervous.

Markets had been pricing in three rate hikes in 2018, but suddenly the spectre of four hikes loomed large.

As an unintended casualty of the inevitable rise in interest rates, fixed maturity bond funds have been losing their shine. These closed-ended funds typically package US dollar-denominated single bonds with a maximum maturity close to the fund’s expiration date. A duration of two or three years is popular among Asian investors.

Floating investors' boats

However, in an environment where yields on risk-free bonds such as US Treasurys are rising, the allure of fixed-maturity plans (FMPs) that yield around 3% or 4% is diminished.

‘Now, people want an income product that is actually pegged to Libor [the London Interbank Offered Rate], meaning it has a floating-rate feature to it,’ said James Cheo, senior investment strategist at Bank of Singapore.

‘You add that floating-rate component and it makes sense. Over time, as interest rates go up, the bonds get repriced, so you don’t lose on the capital and at the same time you get higher coupons,’ Cheo said.

Investors can typically expect Libor plus 200 basis points from such instruments, he added.

In January, for example, Standard Chartered launched an FMP containing US dollar-denominated Asian bonds, including sovereign, quasi-sovereign and corporate debt, maturing in 2020.

In addition to the floating-rate component, leverage is important to ensure that the yield isn’t compromised, according to Ron Lee, chief investment officer of multi-family office Wealth Management Alliance.

To succeed this year, fixed-maturity bond fund managers will also have to be active, rather than reactive, he added.

Some private banks in Asia have been using leverage of up to 80% when selling FMPs. While that makes returns more attractive for the client, significant leverage could lead to losses in the event of default.

FMPs grabbed headlines in 2016 and 2017, with Bank of Singapore, Credit Suisse and Julius Baer raising hundreds of millions in US dollars from clients in Asia. However, the story now seems to have changed as the rate
environment becomes trickier.

Active advantage

Today, Lee is not putting any client money into FMPs and is instead looking for very active bond fund managers. ‘I looked at one FMP with a three-year duration. It was predominantly investment grade. The return was 2.8% to 3%, but to me, I’m taking a leap of faith in a manager being proactive. At the same time, the returns are somewhat diminishing as interest rates increase.’

He named two asset managers that he currently works with – Stratton Street and Silverdale Fund Management.

The Silverdale Bond fund has had trailing returns of 8.8% before dividend payouts over the past three years. The fund, 75% of which is investment grade, uses leverage and actively manages the portfolio duration.

‘This year, the manager has to be active because rates are going higher,’ Cheo said. ‘Before that, yields were going down so you could gain a lot by passively investing. But this year, with bond yields starting to peg higher, managers have to proactively manage bond portfolios, deciding how much duration they should take, where the coupon opportunities lie, how much to put in floating-rate bonds and so on.’

In terms of duration, many bond fund managers are recommending a  duration of less than five years, he added.

In fact, according to Cheo, unconstrained bond funds make more sense than a concentrated position in a few low-yielding bonds with high duration. Unconstrained bond funds – strategies agnostic to particular fixed income sectors – have been popular among private banks in the past year, with Pimco GIS Income one of the most widely cited names in Asia.

‘Unconstrained bond managers can adjust duration exposure and make changes to protect the portfolio value and, at the same time, also find different investments that can benefit in a rising yield environment,’ Cheo said.

Adapting to the new normal

Fixed income is a typical go-to asset class for Asian investors, who tend to have a much larger exposure to it than to riskier assets such as equities. However, amid rising rates and a nine-year bull market, most wealth managers have been advocating equity investments.

Some high-net-worth individuals don’t need the regular stream of income from coupon payments, Lee said.

‘When I look at portfolios, there is often an overweight tilt on fixed income in search of higher yields at the expense of lower grades and taking  unnecessary risk from a credit grading perspective. I think investors should lighten up a bit and consider growth opportunities, because growth is still out there.’

This article was published in the May issue of the Citywire Asia magazine.

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