11 September 2013
"Sell in May and go away" - the old Wall Street adage seems to have been the best advice for fixed income investors this year... or maybe not!
Since May 21 when US Federal Reserve chairman Ben Bernanke first hinted at a gradual scale down of the quantitative easing program, a mini-storm has been brewing in the bond markets. US Treasury bonds, which act as a benchmark for bond prices worldwide, including the GCC region, were sold off, taking the yields on the 10-year bonds from a low of 1.61% on May 1, 2013 to a high of 3% on September 5, 2013.
Bond prices across GCC have softened, but the selloff has not been as severe as in the emerging markets. Emerging market bonds, equities and currencies witnessed a stampede of investors unwinding their carry trades. The relative performance of GCC and emerging market bonds is given in the table below:
Source: JP Morgan and Nasdaq Dubai
CONTRIBUTING FACTORS
There are a number of factors that have contributed to the outperformance of GCC fixed income securities and, within GCC, the outperformance of sukuk:
MIXED OUTLOOK
The general outlook for bonds is fairly divided.
On the one hand, there are analysts who believe that we are going to witness a selloff like the one in 1994 when the Fed doubled interest rates in less than a year. That tightening pushed up yields of the heavily indebted Asian economies and, together with a strengthening dollar, made Asia's US dollar exchange-rate pegs unsustainable. These factors contributed to the onset of the Asian financial crisis in 1997 and the Russian crisis in the following year. The current rout in emerging markets does look like a repeat of 1994.
On the other hand, many analysts point to an uneven recovery in the US economy. The labor market is slowly recovering, but the average rate of jobs growth in 2013 is below that seen in 2012.
Inflation rate remains well below the Fed's target of 2%. Since mortgage rates started picking up after Bernanke's comments in May, there have been some signs of weakness in mortgage applications and home sales. Leading indicators on consumer spending have prompted economists to cut their forecast for GDP growth.
With this backdrop, it may be premature for the Fed to start tapering the stimulus. This group of analysts believes that the market has over-reacted to Bernanke's comments and 10-year Treasury yields could very well be back at 2.5% levels by year-end; then very gradually adjust upwards before tracking the real recovery in the US economy.
HOPES HIGH ON GULF BONDS
It is fair to say that the Federal Reserve does not want a disorderly exit - it is in no one's interest. However, it is possible that Bernanke, who is serving his last few months in office, does not want to be remembered as a guy who averted another Great Depression by flooding the markets with cheap liquidity.
Probably, he also wants to be remembered as a responsible academic who initiated the normalization of his own unconventional monetary policy. Therefore, it is quite likely that a symbolic reduction in the USD 85 billion per month bond buying program may be announced this month.
The market seems to have already factored that in. Now, if there is a marked slowdown in the US economic activity or a pause in tapering or the extent of tapering is less than anticipated, we could actually see the bond yields come down significantly in the coming months.
GCC bonds and sukuk, for the reasons mentioned before, may continue to outperform on a relative basis and provide higher risk adjusted return over the medium to long term. They may remain an attractive alternative for clients seeking to beat the prevailing cash rates that are expected to remain soft for an extended period of time.
Deepak Mehra is head of asset management and advisory in Commercial Bank of Dubai Investment Group. He has been instrumental in launching one of the first local fixed income funds in the region, the closed-ended Al Dana UAE Fixed Income Opportunity Fund in Feb 2009 and later the Al Dana GCC Income Fund and Al Dana Murabaha Sukuk Fund.
© Zawya 2013
"Sell in May and go away" - the old Wall Street adage seems to have been the best advice for fixed income investors this year... or maybe not!
Since May 21 when US Federal Reserve chairman Ben Bernanke first hinted at a gradual scale down of the quantitative easing program, a mini-storm has been brewing in the bond markets. US Treasury bonds, which act as a benchmark for bond prices worldwide, including the GCC region, were sold off, taking the yields on the 10-year bonds from a low of 1.61% on May 1, 2013 to a high of 3% on September 5, 2013.
Bond prices across GCC have softened, but the selloff has not been as severe as in the emerging markets. Emerging market bonds, equities and currencies witnessed a stampede of investors unwinding their carry trades. The relative performance of GCC and emerging market bonds is given in the table below:
| Index | YTD Aug 2013 | Last 3 months | |
| JPMorgan Emerging Market Bond Index | -9.84% | -6.70% | |
| HSBC/Nasdaq Dubai GCC Conventional US Dollar Bond Index | -3.23% | -2.68% | |
| HSBC/Nasdaq GCC Sukuk Index | -2.04% | -2.53% |
CONTRIBUTING FACTORS
There are a number of factors that have contributed to the outperformance of GCC fixed income securities and, within GCC, the outperformance of sukuk:
- High crude oil prices driven by signs of recovery in the West and regional political tensions provide support for the petrodollar economies in the region.
- Liquidity in the GCC bond markets is limited by global standards as the regional bond market does not form part of the global bond indices. Many of the regional institutional investors are buy-and-hold investors. Therefore even though the bond prices have declined, this is on the back of fairly limited trading activity.
- Any sell off by international investors brings out more money from regional institutions to swoop up the bonds and allocate them to their hold-to-maturity portfolios. Over the last few years, allocation patterns have shown that local and regional investors have received much higher allocations in new sukuk issuance as compared to conventional bond issuance. This has helped sukuk outperform conventional bonds during this volatile period.
- Most GCC currencies are pegged to the dollar and have therefore not been affected by currency pressures evident in a number of other emerging and frontier markets. This gives a unique safe-haven appeal to GCC bonds.
- GCC bonds were not one of the prime beneficiaries of the liquidity created by quantitative easing and hence have not seen significant selling pressure from retreating funds.
- Many regional investors have a detailed understanding of regional credits and meaningful amounts of liquidity to deploy. They see the current sell-off as an opportunity to invest in the regional fixed income market at more attractive levels.
- Issuance of new bonds has virtually come to a stand-still since May. This has helped in keeping the supply in check.
MIXED OUTLOOK
The general outlook for bonds is fairly divided.
On the one hand, there are analysts who believe that we are going to witness a selloff like the one in 1994 when the Fed doubled interest rates in less than a year. That tightening pushed up yields of the heavily indebted Asian economies and, together with a strengthening dollar, made Asia's US dollar exchange-rate pegs unsustainable. These factors contributed to the onset of the Asian financial crisis in 1997 and the Russian crisis in the following year. The current rout in emerging markets does look like a repeat of 1994.
On the other hand, many analysts point to an uneven recovery in the US economy. The labor market is slowly recovering, but the average rate of jobs growth in 2013 is below that seen in 2012.
Inflation rate remains well below the Fed's target of 2%. Since mortgage rates started picking up after Bernanke's comments in May, there have been some signs of weakness in mortgage applications and home sales. Leading indicators on consumer spending have prompted economists to cut their forecast for GDP growth.
With this backdrop, it may be premature for the Fed to start tapering the stimulus. This group of analysts believes that the market has over-reacted to Bernanke's comments and 10-year Treasury yields could very well be back at 2.5% levels by year-end; then very gradually adjust upwards before tracking the real recovery in the US economy.
HOPES HIGH ON GULF BONDS
It is fair to say that the Federal Reserve does not want a disorderly exit - it is in no one's interest. However, it is possible that Bernanke, who is serving his last few months in office, does not want to be remembered as a guy who averted another Great Depression by flooding the markets with cheap liquidity.
Probably, he also wants to be remembered as a responsible academic who initiated the normalization of his own unconventional monetary policy. Therefore, it is quite likely that a symbolic reduction in the USD 85 billion per month bond buying program may be announced this month.
The market seems to have already factored that in. Now, if there is a marked slowdown in the US economic activity or a pause in tapering or the extent of tapering is less than anticipated, we could actually see the bond yields come down significantly in the coming months.
GCC bonds and sukuk, for the reasons mentioned before, may continue to outperform on a relative basis and provide higher risk adjusted return over the medium to long term. They may remain an attractive alternative for clients seeking to beat the prevailing cash rates that are expected to remain soft for an extended period of time.
Deepak Mehra is head of asset management and advisory in Commercial Bank of Dubai Investment Group. He has been instrumental in launching one of the first local fixed income funds in the region, the closed-ended Al Dana UAE Fixed Income Opportunity Fund in Feb 2009 and later the Al Dana GCC Income Fund and Al Dana Murabaha Sukuk Fund.
© Zawya 2013
