Asian investors seek dangerous protection

Thu Feb 7, 2013 9:59pm EST

* Investors seek junk as protection against rising rates

* Double-B now more correlated to Treasuries

* Spread products are scarce in Asia

By Christopher Langner

Feb 7 (IFR) - Asian investors have increased their holdings of junk rated bonds in the past month partly to protect themselves against higher yields for benchmark rates by year-end. That strategy, however, may not work so well this time around, analysts warned.

Asian markets saw more than US$12bn in sub-investment-grade and unrated dollar debt issued in January, an absolute record. Every transaction was several times oversubscribed amid pent-up demand for the asset-class.

Credit analysts in Asia have partly attributed the spurt in high-yield demand to managers seeking to reduce their exposure to US Treasuries.

Traditionally, bonds with larger coupons move in tandem with stock markets, while investment-grade debt follows US Treasuries.

Risk appetite and a strong economic backdrop often translate into gains for stocks and junk bonds, while prices of US Treasuries and German bunds drop, as well as most investment-grade bonds that are benchmarked against them.

That move has already started as investors have become more upbeat about the United States economy. The yield on the 10-year Treasury spiked in January, closing over 2% on Monday for the first time since April last year.

And while the yield has dropped back below 2%, the 1.95%-2.05% range it seems to be settling in is also 20bp wider than the range in which it traded in December. Treasury volatility has almost doubled in the past two weeks as well.

Stronger than expected employment data in the US last Friday added to expectations that Treasury yields could end this year even higher.

This suggests the need to protect fixed income portfolios against drops in the prices of low-coupon bonds, and Asian investors seem to have elected buying high-yield as the strategy to do so.

The problem, however, is that high-yield may not be such a good alternative to seek refuge from volatile Treasury rates anymore.

The drop in yields of junk bonds has reached such an extent, that their correlation may be closer to Treasuries than to stocks now. "The view that 'high yield' is somewhat immune and that the danger lies in high grade may be the wrong conclusion at these historic 5%-6% yields for Double B credits," said Owen Gallimore, head of credit strategy at ANZ.

The alternative, said one analyst, is to buy spread products to offset potential losses from rate moves. Usually, when Treasury rates rise, investment-grade bonds in Asia drop, but not as fast as the benchmark. That means that the difference in yield between these securities and Treasuries, or spread, is reduced.

Hence, the gains in five-year credit default swaps for Indonesia, for instance, would partially offset losses in the sovereign bond's price in the case of a Treasury yield spike. In fact, in its outlook for 2013, Morgan Stanley predicted a 50bp rally in average investment-grade spreads in Asia this year.

The problem, however, is that there hardly is any corporate CDS in Asia, so investors are left only with sovereign contracts to use as hedge.

While these contracts may reduce losses from a spike in Treasury yields, they do not offer the recurring coupon payments that high-yield bonds do. Therefore, given the options, investors have shown that they prefer to hold junk bonds as a hedge instead.

That would usually work, but this may not happen in a time when the average yield to maturity on the bonds that comprise the Merrill Lynch Asian Dollar High Yield Index is at 5.94%, a near record low. These days, high-yield are as close to Treasuries as they have ever been.

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