With only weeks to go until we enter 2021, investors can be forgiven if they eye the next 12 months with a small portion of optimism. We do realise that a simple date change won't erase the current environment; however, after the difficulties and uncertainties we have experienced there may be some cleaner light at the end of the proverbial tunnel. For example, the VIX Volatility Index, which hit a high of 82.7 in March has been trading pretty steadily in the 20s since August. And the capital markets have even taken the US election in their stride. What's more, there is now some clarity about where the bond markets are headed.
Sovereign issuance remains robust, with investors snapping up higher-rated and longer-tenor debt, in particular. Sustainable investments and environmental, social, and governance (ESG) bond issuance has not only been the standout star of the year, but demand from investors is only likely to grow. Meanwhile, emerging-market debt in Asia remains a steady bedrock.
Against this backdrop, I want to look at three investment themes that balance any risk aversion that may linger but still show returns.
A Reliable Hedge
Government debt has been the cornerstone of most portfolios for much of the year. Safe-haven bonds are also likely to remain a reliable hedge for the rest of 2020 and into the first quarter of next year, as the markets navigate several risks.
Indeed, the scale of the demand can be seen from the reception to recent issues in Asia. At the end of September, the Australian Office of Financial Management, which sells debt securities on behalf of the Australian government, received bids two and a half times the A$25 billion (US$17.7 billion) that were on offer for its new 0.5% 2026 bonds1.
This dynamic was even more apparent in mid-October, with a blockbuster US$6 billion four-tranche bond deal from China, acting through the Ministry of Finance2. Books were four and a half times oversubscribed for the three, five, 10- and 30-year bonds. More to the point as the first China sovereign bond to print in a 144a format for 16 years, investors flooded in from around the globe.
They have been attracted by the high ratings (Australia is rated Aaa/AAA/AAA while China is A1/A+/A+) and the ability to hedge against riskier assets, as well as the attractive liquidity of government paper.
The Shift Towards ESG
It's no secret that bond markets are perfectly happy to ignore trends and themes when it suits, but there has undoubtedly been a shift towards ESG-related debt, particularly that which is investment grade, since March.
It remains structurally the most innovative part of the fixed-income space. Across the region there have been, for example, university bonds which address accessibility issues for students during the coronavirus pandemic, financing for geothermal projects, as well as blue bonds where the proceeds are used to fund new and existing marine-related projects.
Alternative investments like this are going to remain popular for the foreseeable future for three reasons. Firstly, they bolster the ESG credentials of investors; secondly, the issuers are often highly rated themselves; and finally, because ESG investments are generally positively regarded or supported by central banks they are perceived as having an additional layer of safety.
Not only do they generally provide a yield pick-up over government bonds, but ESG investments have also consistently outperformed traditional investments during Covid-19 by 3 to 4 per cent across the globe3.
Emerging-Market Debt Remains Attractive
Emerging-market local-currency debt was one of the standout winners earlier this year returning 7.7% in the second quarter, and it is likely to remain attractive for the foreseeable future4. Even though the yield on Asian local currency bonds has tightened dramatically over the past six months, it still provides a clear yield pick-up over US Treasuries.
Ten-year paper from Vietnam, Malaysia, and Indonesia for example, might have come in 67.8 basis points (bps), 67.7bps and 110.3bps respectively since April. However, they still offer a healthy return over equivalent US Treasuries5.
This is also true in the Asian local-currency corporate-debt domain. The markets have remained open for companies across the ratings spectrum: even the unrated have been able to raise capital from the third-quarter onwards.
The low interest-rate environment is expected to continue into next year, regardless of who wins the election on 3 November. On top of this, a decline in the US dollar which is currently overvalued by more than 8% and which some economists believe could plunge as much at 35% next year is likely to support local currency bond valuations in Asia even further6.
Risks do remain and the global economy will remain covid-sensitive for some time yet. On balance, though, positives forces are holding their ground. The return to growth in many Asian economies will support the expansion of capital markets, which, in turn, provides a solid foundation for the region's bond markets.
3 Source: Tracy Wong Harris, deputy secretary-general of The Hong Kong Green Finance Association quoted in the Alternative Credit Council's (ACC) report on private credit in Asia https://acc.aima.org/resources/research/private-credit-in-asia.html
4 Source: State Street figures
5 Source: www.worldgovernmentbonds.com, as of 14 October 2020.
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