Investing: Bond market to face headwinds as inflation climbs

This article first appeared in Wealth, The Edge Malaysia Weekly, on November 29, 2021 - December 05, 2021.
Investing: Bond market to face headwinds as inflation climbs
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While industry experts expect inflation to remain elevated in 2022, there is no consensus on how long this situation will last. Bond markets globally are expected to face headwinds as interest rates rise while bond prices fall. Still, local bond fund managers are not that pessimistic.

Sani Hamid, director of economics and market strategy at Singapore-based independent financial advisory firm Financial Alliance Pte Ltd, says inflation globally is expected to remain high next year on the back of supply chain disruptions and the reopening of the global economy.

Already, consumer prices in the US soared to 6.2% last month, a rate not seen in the past 30 years. “Some were surprised, but it was just a matter of time that inflation started to show up. And it finally did. The biggest question now is whether it is transitory,” says Sani.

“My view is that it will remain transitory, but for a longer time instead of one to two months. Supply chain disruption, like chip shortages, is a structural issue that needs more time to [resolve]. It will also take time for people to return to work.”

"We have seen a number of our conservative portfolios [that invest in bond funds] making very little [returns] recently, with some even underwater. It was our more aggressive portfolios [that invest in equities] that are doing better.” - Sani (Photo by Financial Alliance)

The low-base effect would also make inflation numbers in the coming months look high. “By and large, they should seem elevated throughout 2022,” he adds.

Rising inflation and the possibility of a rising interest rate environment are seldom good for the bond market, as evidenced by the underperformance of some bond funds in the market, says Sani.

“We have seen a number of our conservative portfolios [that invest in bond funds] making very little [returns] recently, with some even underwater. It was our more aggressive portfolios [that invest in equities] that are doing better.

“Bonds are a more contentious asset class this year.”

Sani advises his clients to switch their bond holdings to money market funds, which are steadier in price. The lower returns generated by money market funds, compared with bond funds, are compensated by a higher allocation into equities, mainly thematic funds that invest in technology, climate change and commodities companies.

Sani observes that some bond funds in Europe have amended their mandates to allocate some money into equities before bond prices could take a further hit from higher inflation and interest rates.

“The change allows them to incorporate a little more risk [for potentially higher returns].”

Investors should keep an eye on the China bond market, adds Sani. A large number of corporate debts will be due next year, with the country’s high-yield bond rates sometimes going as high as 25% a year at the moment. What if they fail to refinance their existing debt at such a rate?

“It leaves everybody thinking that, if more companies with weak fundamentals go down the drain, this would create negative sentiment that affects bond markets globally,” he says.

"We believe price pressures will ease as the underlying economy recovers and supply curves catch up with demand.” - Teo (Photo by Affin Hwang)

Key factors that could keep inflation high beyond next year

Esther Teo, senior director of fixed income at Affin Hwang Asset Management Bhd, concurs with Sani’s view that rising inflation is transitory, but she expects inflation rates to trend downwards next year instead.

She says the current price pressures are mostly concentrated in areas in which supply chain disruptions are most severe, including the automotive, energy and shipping sectors.

“We believe price pressures will ease as the underlying economy recovers and supply curves catch up with demand,” she says.

Teo expects inflation to remain subdued over the long term, owing to structural issues at play, including the digitalisation trend that could drive down the cost of doing business and accumulation of debt, and income inequality that could suppress overall market demand.

“We believe these disinflationary forces are more powerful than the current supply chain shortage that we are seeing,” she adds.

Yet, Teo and her team are mindful that the risk of runaway inflation is rising and they are constantly monitoring market indicators that may contradict their view. A key indicator is the US five-year forward inflation rate, which remained anchored at 2.3% as at Nov 16.

Meanwhile, Teo expects the US Federal Reserve to hike rates by 25 basis points (bps) in the second half of next year (2H2022) if inflationary pressure persists on the back of economic recovery.

Aggressive Fed rate hikes — meaning, more than 50bps, which is currently priced in by the market — are unlikely unless inflation proves to be stickier than projected, she adds.

As emerging markets have started their rate hike cycle in 2021, owing to ongoing inflationary pressures, Teo expects central banks in the developed markets to begin raising rates in 2H2022. That would be part of their normalisation process of an extremely accommodative monetary policy, with the global economic recovery underway.

On the local front, Teo expects the overnight policy rate to be maintained at 1.75% at least until 1H2022, with a potential 25bps-to-50bps hike in 2H2022, depending on the country’s economic growth and inflation trajectory.

Pockets of opportunity in the market

If inflation trends down next year and remains subdued over the longer term, there are investment opportunities in the bond market, says Teo.

Judging from bond prices as at Nov 16, she says, the global and local bond markets have priced in more than one rate hike next year, which could mean that bonds, in general, are oversold. “For instance, the market is currently pricing a rate hike of close to 75bps in the US and Malaysia, versus our view of 25bps to 50bps,” she says.

Teo and her team feel more comfortable deploying cash into the market next year as bond yields rise. “In our view, 2022 should be a better year for bond investors after this year’s sell-off. Yields are now at a higher level and we do not foresee a sustained increase in yields next year.

“Investors who are seeking long-term stable returns should consider increasing exposure on fixed income to take advantage of higher yields,” she says.

Roszali Ramlee, managing director and CEO of AmanahRaya Investment Management Sdn Bhd, shares Teo’s view. He says the markets have factored in three rate hikes next year whereas the firm expects only one.

“The market seems to have overreacted. That’s why in the last few weeks, our bond market prices have recovered a bit,” says Roszali.

He adds that volatility in the bond market is expected to heighten next year, with fund managers more actively trading some of the liquid papers, such as Malaysian Government Securities, to generate better returns. “The ones who perform better next year will be the ones that actively manage their portfolios.”

However, Roszali prefers investment grade corporate bonds over government bonds, whose prices are less sensitive to interest rate fluctuations. “We don’t like government and government-guaranteed bonds, as their yields are low. They are susceptible to news flows too.

“We like corporate bonds, especially those with double-A ratings with higher yields. And we focus on managing the duration and credit risk of these bonds,” he says.

Demand and liquidity in the local bond market are still high, as institutional investors, which are dominant players in the market, have been keeping cash. Roszali is expecting bond funds under the firm to generate 4% to 6% returns to investors this year, with a minimum target of 1% higher than fixed deposits.

“As for this year, our AmanahRaya Syariah Trust Fund yielded investors a 6% return, which is still decent,” he says.