Opposing Forces – Navigating Inflation and Delta

Rising inflation is placing upward pressure on yields, while the surging Delta variant is dampening risk sentiment. How should bond investors navigate such competing forces?

Asia Pacific Head of Fixed Income, Head of SSGA Singapore

With the two major themes of rising inflation and the rampant Delta variant dominating headlines, investors across all asset classes are assessing how these risks will affect their portfolios. However, bond investors arguably face a greater degree of uncertainty. This is because – unlike equities – inflationary forces and a surging pandemic are exerting opposing pressures on fixed-income prices.

On the one hand, higher inflationary expectations tend to push yields upward (and prices downward). Consequently, investors expect central banks to respond by tightening monetary policy, which means either raising interest rates or scaling back their bond-purchase programs.

Meanwhile, the fast-moving Delta variant is dulling economic confidence – casting doubt over whether the strong economic recovery initially projected earlier in the year will materialize. So, as risk appetite dips, investors tend to gravitate toward bonds markets. The likely result from such inflows is higher prices and lower yields.

In Asia, we already see signs of these clashing pressures.

Bank of Korea Hikes Rates While Inflation Causes a Spike in Chinese Bond Yields

On 26 August 2021, the Bank of Korea hiked its policy rate by 0.25% – the first increase in almost three years 1 . This was also the first attempt by a leading Asian central bank to shift away from the accommodative monetary policy prevalent amid the pandemic. The bank’s governor also maintained a hawkish tone, signalling that further rate increases were likely.

Since the announcement, the yield on 10-year Korean government debt has trended upward – rising by 0.145% till 17 September 2021 2 . Of course, inflation was just one of the factors that underpinned this rate hike. The central bank was also concerned about the potential threat that spiralling consumer debt could have on the economy.

Meanwhile, in China, data for August showed that factory-gate inflation had hit 9% – a 13-year high – causing the yield trend to reverse3 . Its 10-year government bond yield had been falling since mid-June 2021. But the surprise inflation data caused the most significant single-day spike since July 2020 4

Surging Delta Variant Dampens Risk Sentiment

At the same time, however, the Delta variant’s continued spread across the region has dampened risk sentiment and held back other potential rate increases. For instance, even in South Korea’s case, policymakers indicated the possibility of higher rates since May 2021 5 . However, a fourth pandemic wave then spurred tougher lockdowns – likely causing a pushback in the timing of the rate hike.

The impact of these developments on Asian fixed income has varied, depending on credit quality. High-yield bonds, for instance, have fallen sharply since June 20216 .

Government bonds tell a different story. While there are fluctuations, yields have generally remained relatively stable across the board 7 . This was even the case in South Korea and China. While the yield on 10-year South Korean government debt has been increasing since the rate hike, it remains below 2021 highs8 . And in China, while yields did rise on the back of inflation data, they are still significantly below levels seen in the past few months9 .

Such data could point to the most optimal way for bond investors to navigate the twin risks of rising inflation and a surging Delta variant.

Taking the Longer-Term Perspective

No one knows how the combination of the inflation story and the Delta variant will play out in the immediate term. By extending our horizon toward the longer term, we can look beyond such short-term uncertainty and ask the critical question: what type of fixed-income assets can provide a balance of good yield, acceptable risk, and diversification?

Our perspective is that local-currency Asian sovereign bonds meet these longer-term criteria. On the yield front, there is still a good pickup available. For instance, as of mid-September 2021, China’s 10-year government bond offered a 1.55% yield advantage over US 10-year government bond. In South Korea, this number is 0.76%, while for countries like Indonesia and Malaysia, the yield pickup stands at 4.79% and 1.95%, respectively 10,11  . 

Importantly, their sovereign status means investors get to enjoy additional yield without giving up too much in terms of credit quality. This is not the case for corporate bonds. Meanwhile, the diversification benefits from holding local-currency Asian sovereign bonds help tip the scales even further.

Risks Remain – but Asian Sovereign Bonds Look Good on Balance

We must still acknowledge and be mindful of the risks – especially in the weaker countries. For instance, vaccination rates in Indonesia, the Philippines, and Thailand are still relatively low 12,13  . Indonesia’s continued debt monetization also presents risks14 , although the government has scaled back on its issuances, mindful of the growing deficit 15,16  .

On balance, however, the prognosis for Asian sovereign bonds remains good. Other than the previously mentioned factors, Asian economies are also much better protected against any tapering by the US Federal Reserve. This is thanks to higher foreign reserves, improved current account balances, and undervalued currencies17 . Investors seem to agree – overall, Asian bonds have seen foreign inflows for 15 consecutive months 18.

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