By Manpreet Gill

For income investors, the level of bond yields is starting to look exciting again after what has been a long lull. Compared with a world of historically low (in many cases zero) interest rates for most of the past decade, yields on many bond asset classes are now approaching multi-year highs as the Fed lifts US Dollar policy rates.

With yield premiums on several riskier bond asset classes also rising this year, it may once again be interesting to start scouring the fixed income world to look for attractive opportunities.

Investors, of course, should be aware that higher yields do come with their own risks. Wider yield premiums on riskier bonds are often reflective of higher default risks, a factor that has been a challenge in several Emerging Markets in recent months, for example. Rising interest rates have also meant that the cost of funding for companies and governments has risen alongside.

Financial markets rarely offer a free lunch, but an understanding of the risks involved would enable investors to be better prepared to assess which risks are worth taking in today’s environment, and which ones are not. In general, bond investors can take on three major types of risks to generate a yield:

1. The first is maturity, or ‘duration’ risk. In general, an investor takes on more risk by owning a long maturity bond (eg. a 10-year bond) than a short maturity bond. Holding a longer maturity bond carries the risk of repayment for a longer period. Longer maturity bonds also tend to be more sensitive to changes in interest rates, raising the risk of price volatility. Therefore, in general terms, longer maturity bonds tend to offer a higher yield than shorter maturity ones.
2. The second is credit risk. Buying a bond is akin to lending money to the bond issuer in return for an interest (or yield). Generally, the riskier the bond issuer, the higher the yield demanded by markets. For example, higher yielding bonds usually have a higher probability of default than investment grade bonds, which is why the former offer a higher yield. Government bonds are usually less risky but, as several hundred years of bond market history shows, they are not entirely immune to default risk either.
3. The third is currency risk. The Emerging Market local currency-denominated bond asset class, for instance, offers a basket of bonds that are denominated in a mix of EM currencies, instead of the benchmark US Dollar. It offers investors an alternative that helps them diversify away from US Dollar-denominated bonds. However, it comes with the risk of significant changes in the underlying currencies, which could lead to gains or losses on the bonds for a US dollar-benchmarked investor. This currency risk arises in addition to the risk from any changes in local currency bond yields.

Assessing today’s markets based on the above risks, we see less value in taking on a significant amount of maturity risk. Higher maturity bonds can be very attractive when the gap between long and short maturity bonds is wide. Today, however, this gap is at the narrower end of its historical range. Hence, on average, we favour shorter-to-neutral maturity profiles for bond allocations.

We do, however, see opportunities in taking on selective credit risks. For instance, Asia USD bonds offer investors the combination of regional diversification with an attractive risk/reward profile. This asset class also offers investors relatively high yields for a basket overwhelmingly composed of investment grade bonds. However, we also believe a diversified basket of US and European corporate bonds should be a core holding in well-diversified portfolios.

Finally, we continue to lookout for opportunities to take on currency risk through local currency bonds, usually in Emerging Markets. For now, we see this as a core holding within a diversified portfolio – rising interest rates across many Emerging Markets and inexpensive valuations of Emerging Market currencies are key attractions that should support returns in this asset class. However, the main headwind continues to be the prospect of currency losses in the near term eroding the yield as the US Dollar continues to strengthen. The US dollar will likely need to peak before this asset class starts to outperform other bonds.

(Manpreet Gill is Chief Investment Officer for Africa, Middle-East and Europe at Standard Chartered Wealth Management)