Wednesday, August 7, 2024

Bonds and S’pore equities tipped as investment options amid expectations of US rate cut

2024-08-07

SINGAPORE – Expectations that United States interest rates are heading down soon are tipped to affect yields on both short and long-duration bonds – outcomes that will impact investors here.

Markets are reacting to indications that the United States Federal Reserve will cut rates by up to 50 basis points in September to a range of 4.75 to 5 per cent.

When that happens, the entire yield curve moves lower, meaning rates on short- and long-duration debt securities come down.

Mr Sani Hamid, director of economics and market strategy at financial advisory firm Financial Alliance, said it is slightly different this time as short-term rates will fall but longer-term ones will not come down and could rise instead.

This is because the US is highly indebted and will have to issue more long-term bonds to fund its deficit.

Bond prices and yields are inversely related. When there are more bonds, prices fall and their yields go up. 

With longer-dated yields expected to rise, market watchers said investors should beware of buying long-term bonds – those with durations of 10, 20 to 30 years – but shorter-duration ones remain a viable option.

“Three years is not too long, it is near to the front end of the yield curve,” Mr Sani added.

A recently launched DBS three-year fixed income fund comprises a globally diversified portfolio of 50 investment grade corporate bonds and low-risk government bonds. The fund is open to retail investors in US and Singapore dollar versions.

Investors can expect an indicative yield in the range of 4.5 to 5 per cent a year for the US dollar share class of the fund. The Singdollar class is expected to have a net yield of 3.2 to 3.5 per cent a year. 

DBS chief investment officer Hou Wey Fook said over the last six hiking cycles, bonds outperformed cash significantly in the three-year period after a pause in US interest rate hikes. 

Mr Hou added that the Fed is now at the peak of its hiking cycle and the next move will be lower, so investors could consider fixing returns at current yields, as opposed to holding cash, which has high reinvestment risk when rates are to be cut. 

High reinvestment risk means investors may not be able to reinvest their cash at a rate comparable or higher than the current one.

Mr Thomas Drissner, head of Asian credit research at asset manager abrdn, noted that it has become harder to find compelling opportunities in bonds, as credit spreads, which are the premiums investors get paid for accepting default risks, have narrowed.

Mr Drissner’s strategy is to go for short-dated credit of under two years’ duration.

He manages a fund at abrdn that captures yields on short-dated government bonds and seeks to enhance returns by investing across developed and emerging corporate bond markets. The fund has a yield of approximately 6 per cent a year.

Even as the hunt for yields intensifies, investors need to pay attention to the bond quality, said Mr Sani, who added that this is especially the case now with the global economy entering a slowdown and many companies starting to default.

“Even though rates are coming off, a lot of them are at a point where they cannot sustain their debt payments any more,” he noted.

Mr Hou said investors could consider holding investment grade bonds. These are debt of issuers that have strong balance sheets and cash flows so they are better able to ride through recessionary conditions.

“Investment grade bonds have historically not seen defaults exceed 0.5 per cent in any one-year period,” Mr Hou noted, adding that this was also the case during crisis periods such as in 2001, when the tech bubble burst, and in the 2008 global financial crisis.

On the other hand, major equity markets have done better than bonds so far in 2024 and the high expectations have been baked into equity prices, Mr Drissner of abrdn said.

An allocation to bonds allows investors to diversify their portfolios and buffer against any volatility if equity prices correct, he added.

Mr Rob Almeida, global investment strategist at MFS Investment Management, noted that US companies face the most downside risks.

He said investors are too focused on interest rates, which is taking the emphasis away from the need to understand a company’s business fundamentals and how it will fare in the current business landscape.

He added that the recent sell-off was the market’s way of acknowledging and discounting its expectations that incomes were too high.

Since Aug 1, US markets have corrected as investors worry that the world’s largest economy is heading into a recession.

The Dow slipped 4.1 per cent between Aug 1 and Aug 5 but remains 2.7 per cent higher so far this year. The Nasdaq was down 5.8 per cent during the same period, but is still 7.9 per cent higher year-to-date.

As for the S&P 500 Index, it lost 4.8 per cent between Aug 1 and Aug 5. So far in 2024, the S&P 500 Index remains 8.7 per cent higher.

Mr Sani said US stocks look a bit shaky at this moment. He added that there are signs money is flowing out of the US and into laggard markets like Singapore and Malaysia. “So it is not advisable to jump into US stocks now,” he noted.

And while Singapore and Malaysia equities have run up in July, Mr Sani said they remain attractive because both markets have been trading sideways for the past five years and are now playing catch-up.

The Straits Times Index gained 3.5 per cent in July while the Kuala Lumpur Composite Index advanced 2.2 per cent during the same period.

Among Singapore equities, Mr Hou said he likes the banks as a proxy for the economy. He added that the banks’ bottom lines will benefit from loan and fee income growth.

Current valuations are also not demanding and dividend yields of around 6 per cent continue to be attractive, he added.

Real estate investment trusts listed in Singapore (S-Reits) will also benefit from any fall in interest rates, as it will reduce their borrowing costs.

Dividend yields at S-Reits have also been consistent across cycles at 6 per cent on average, Mr Hou noted.

DBS Bank likes retail, industrial, hotels and office Reits in decreasing order of preference, with retail trusts exposed to the suburban space as its most preferred.

Mr Sani is taking a more cautious approach to S-Reits as they have already jumped up a little because of expected interest rate cuts. He said for S-Reits to go higher, there must be more than the three rate cuts that the markets have already discounted into the prices.

“You are talking about four, five, six, seven rate cuts. The big question is, can we get the four, five, six and seven cuts next year?”

Mr Sani added: “Interest rates are not going back to where they came up from. We are not going back to the period where rates are at 0.5 per cent or 1 per cent.

“It will probably come down and stop at 2.5 per cent. To bank everything on interest rate-sensitive sectors is maybe a bit too risky.”

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