Swiss & Global’s Michal Novak sees Swiss fixed income as an overlooked asset class
Michal Novak, fund manager, JB Swiss Franc Bond Fund at Swiss & Global, sees increasing diversification of instruments and issuers in the CHF bond market as key reasons why investors should consider the asset class.
Following a protracted global trend towards lower yields, the yield on ten-year Swiss Confederation bonds bottomed out at 0.37% in December 2012. A trend reversal followed in 2013, with the figure rising to an interim high of 1.28% at the start of 2014. This yield increase went hand-in-hand with negative performance of the overall bond market, which shed 1.30% last year. While this hardly underscores the appeal of the asset class, it nevertheless reveals opportunities.
Foreign issuers of CHF bonds are mostly banks and supranational entities. This segment has grown in recent years and thanks to its diversification in terms of both geography and credit ratings, the segment offers a number of interesting investment stories. As the geographical spread of issuers has broadened, an increasing number of borrowers from emerging markets have made their way onto the Swiss market. The share of foreign issuers accounted for by emerging markets has risen from 5% to more than 10% in the past five years. This stems on the one hand from their improved credit ratings and on the other hand from the average size of a bond denominated in CHF. Whereas hundreds of millions or even billions are needed to find investors with € or $ bonds, CHF100-250m is ample on the Swiss market. This offers an elegant solution for even minor refinancing needs.
A combination of an increase in borrowers from emerging markets, together with a series of rating downgrades, has prompted the share of foreign issuers rated BBB to grow from 3% to over 13%. At the same time, the AAA rating segment of foreign issuers has shrunk from over 42% to less than 26%. Has this meant a corresponding increase in risk? Not necessarily. The importance of the diversification effect must not be underestimated, and this has improved markedly. The number of foreign borrowers has almost doubled with the addition of some 200 new names. In addition, the regional coverage now extends all around the globe. Another boon for risk-aware investors is that the low credit ratings are largely concentrated among shorter maturities, so the risk remains manageable.
The uptrend in yields that is currently under way is not a one-way street. This was made clear at the start of the year. While the central banks’ normalisation efforts continue, yields will not keep rising steadily. Instead, they will be subject to repeated countermoves. These fluctuations are opportunities that can only be exploited with an active strategy. A disciplined approach is crucial in order to limit losses incurred by interpreting signals incorrectly.
The level of yields and the steepness of the yield curve are also key factors. The spread between two-year and ten-year CHF swap rates is still considerable at 110 basis points. Investors can profit from this in two ways: the carry effect, whereby the higher yield level is reflected in current income, and the roll-down effect, which is the time effect of holding a position. Given the current environment for CHF bonds, the combination of the carry effect and roll-down effect compensate for a yield increase of around 30-35 basis points a year.
On the credit side, spreads have now reached levels last witnessed prior to the collapse of Lehman Brothers. While this is partly justified by improved balance sheets, recent developments mean caution is advisable, including where companies borrow in order to pay out dividends, buy back their own shares or make acquisitions. These issues must be analysed carefully. Investors desperately seeking somewhere to place their money often succumb to the temptation of higher returns offered by lower-rated paper and in doing so, underestimate how illiquid this segment of the market can become in a stress scenario. Offsetting a slightly shorter duration to hedge against rising yields with an increased credit position has paid off so far, but it is likely to become more difficult going forward. Selecting the right sectors and borrowers and avoiding certain investments will be the key success factors.
The situation outlined above clearly calls for an active investment style that takes account of all dimensions. The diversification of the CHF bond market in recent years has brought greater opportunities that make it possible to spread security-specific risk more effectively and take up positions that would not have been viable in the past. The quality of the market remains good. Looking at the structural levels of GDP growth and inflation, yields seem fair to cheap at present. During “risk-off” phases in particular, the CHF market proves its worth time and again as a safe haven and tends to outperform. Active duration management on the yield side and security-specific decisions on the credit side will be key to successfully exploiting opportunities in this overlooked market.