Managing bonds while facing interest rate hikes

A panel of bond fund managers gives Hong Kong investors a taste of the possibilities.

Global bond fund management executives argue that the sector offers continuing opportunities despite the looming threat of interest rate hikes in the United States. A panel outlined sectors portfolio managers can exploit to Hong Kong institutional investors at a seminar hosted by Mercer Investment Consulting, if they are given the freedom by clients to diversify a portfolio.

These managers feel pressure to argue that investors shouldn't abandon the asset class. "Rates could even head lower," says Imran Hussain, director at Black Rock, noting that reflation fears may not last. "So a zero allocation to fixed income is not sensible. And if interest rates do rise, that will impact investors' asset allocation decision, because rising rates may also cause equities to trade lower."

This week's setback for Asian equities will have underlined his point. Strong employment figures in the US triggered fears of the Federal Reserve raising interest rates, which led to a minor crash in emerging market equities. More volatility is likely, given the amount of leverage in the financial system, says Hussain. But it's not clear what exactly the Fed will do: it may hint that rates will go up, and let the market adjust on its own; or it will raise rates temporarily; or perhaps it fears inflation is making a comeback and so it will raise rates more severely than expected.

Not all economies are synchronous, however, and not all fixed income sectors respond to higher rates in the same way, Hussain says.

Bond executives these days are uttering the same mantra of diversification, even if their particular recommendations or the products they plug vary.

Investors should vary exposure among money markets, short-duration bond products, fixed and floating-rate global bonds, municipal or corporate credit, high yield or emerging market debt, mortgage bonds and inflation-protected securities, says Brian Baker, regional CEO at Pimco.

Hussain says bond fund managers can adopt a number of trading strategies in the face of possible interest rate hikes. For example, Europe and the US are on divergent economic cycles and he sees no reason for Euroland to raise interest rates further, thus creating arbitrage opportunities. Similarly, investors are now underweighting US duration and overweighting Canadian 10-year bonds. Relative value opportunities are to be found in Europe, as the UK looks like it will keep its current interest rate level steady, which has prompted swap spreads to widen against the euro.

Baker says investors are clamouring for absolute returns as well. For a bond fund manager, that translates as beating Libor, which can be done by taking duration bets that add volatility and risk, but can also provide high alpha, if done in a controlled way. For example, he notes that risk-averse investors overpay for liquidity by piling into money market funds, and portfolio managers can benefit by extending duration bets and selling volatility.

Fund managers are urging institutional investors to give them more leeway, and not just stick to traditional commercial paper, deposits, T-bills and muni bonds, but to use hedging tools such as futures and get exposure to non-correlated segments.

Among the least heralded asset classes, particularly for regional investors, is Asian US dollar bonds. Ben Yuen, head of Asian fixed income at First State Investments, notes the HSBC Asian dollar bond index has outperformed global bond indices since 1997. More importantly it is not correlated and, given the improvement of Asian sovereign credit ratings, may reduce the vulnerability of bond prices to US interest rate rises.