Surf the Sea of Value

Background

While a rising tide lifts all boats, some waves are higher than others. Short-term rates are highly sensitive to central bank actions. As central banks around the world tightened monetary policy, rates at the front-end jumped much more than longer-term rates.

Like a surfer riding on the highest part of the wave, investors generally are keen to take advantage of the curve inversion in US treasuries and the correspondingly high short-term rates.

The simplest way to do so will be to buy short-dated investment grade bonds. However, it is challenging to  find inventory especially in less liquid local currency markets such as SGD and AUD. Additionally, with high demand and limited supply, prices of short-dated bonds are often at a premium.   This has caused a dislocation in the derivatives markets with Credit Default Swap (“CDS”) implied default rates being higher than priced into the cash bond market – it means that simply at the moment the derivatives market is providing higher returns for essentially the same level of risk.

Even in more liquid currency markets such as EUR, CDS trades are wider than bonds of similar tenor and rank in the capital structure, as illustrated by the example in Chart 1 below comparing the CDS curve of Deutsche Bank subordinated debts against the Deutsche Bank bonds of the corresponding debt level.

Credit Default Swaps are highly customisable and can help an investor to achieve their investment objectives

Diving into Bond Yield 101

The yield of a bond can be broken down into:

i. “risk-free” rate which is based on the Treasury curve and;

ii. credit spread or credit risk premium, which can be estimated via the CDS market.

Current Investment Landscape

With the inversion in the Treasury curve (see chart 2), higher credit spreads for long-dated bonds are offset by correspondingly lower Treasury yields at the long end.

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For example, a 10-year maturity extension on Indonesian government bonds would provide  ~1.50% p.a. yield pickup whereas the pickup from the credit spread alone is closer to 2.25% p.a. (see Chart 3). Investors are not well compensated for holding long-dated bonds.

On the other hand, companies generally look to lengthen their debt maturity profile amidst lower long end rates. With high demand and low supply, inventory of short-dated bonds are hard to find.

What does this mean for investors?

Firstly, investors looking to increase yields on their income producing portfolios should be aware that the corporate bond yield curve does not provide a good source of tenor risk premium.  We prefer tactical duration management strategies such as floating rate investments especially for investments beyond 2-3 years.

Secondly, due to the technical demand-supply situation in the bond market, while short duration bonds are optically attractive with yield above 3%, investors may wish to consider higher paying alternatives in the derivatives market which are also available in securitised format.

Lastly, investors who prefer to stick to simple cash bonds should be aware that attractive valuations for short duration bonds are constrained by the supply side situation and trades may take longer to execute.

CONCLUSION

Short-dated bonds are expensive while long-dated bonds do not provide enough term/liquidity premium. This is where credit derivatives can fill the gaps: helping investors increase yields on their portfolios while managing duration risk.

The world is your oyster – you just need to know where to look.