[PB Notebook] Markets with Many Variables... Focus on Safe Asset 'Bonds'

Ihanjae Shinhan Bank Shinhan Family Office Banpo Center PB Team Leader

Everyone is paying close attention to Jerome Powell, Chairman of the U.S. Federal Reserve (Fed). This is because 'interest rates' are whipping all assets. Until last year, interest rates consistently followed the 'Higher for Longer' policy, but now the situation is more complex, requiring predictions of the timing and pace of rate cuts through various real economy indicators.

Historically, an inversion of short- and long-term interest rates has often signaled a high likelihood of recession, but recently, the global financial market remains hot due to the momentum of artificial intelligence (AI) triggered by ChatGPT and others. Stocks in sectors with high growth potential remain attractive. However, since the market consensus is forming that current interest rates are at their peak, it is considered a good time to expand interest in bonds.

There are various investment strategies for bonds, similar to stock investments. Broadly, they can be divided into investments aiming for interest income from holding bonds and those seeking capital gains from bond price appreciation. The former includes strategies such as investing in short-term high-quality bonds, including government bonds, to receive fixed high interest. When investing in short-term bonds during a period of declining interest rates like recently, one must be mindful of the 'reinvestment risk,' which means having to reinvest at lower rates after maturity.

Although not short-term high-quality bonds, recently there has been growing investor interest in contingent convertible bonds with a 5-year call option, which have characteristics similar to perpetual bonds. If current interest rates are considered to be at their peak, investors can secure yields higher than deposits for more than five years. However, since these bonds have a lower priority for loss compensation compared to regular bonds if the issuer becomes insolvent, it is essential to carefully review the creditworthiness of the issuing institution before investing.

For investments seeking capital gains from bond price appreciation, investors tend to invest in medium- to long-term bonds with relatively longer weighted average maturities (duration). Because bond prices fluctuate more with interest rates the longer the maturity, investors can aim for higher returns if they expect interest rates to decline in the future.

However, this strategy carries higher volatility and requires caution. When investing in long-term bonds with maturities over 10 years, it is advisable to focus on government bonds, which have lower default risk than corporate bonds. Additionally, the 'barbell strategy,' which involves investing simultaneously in short-term and long-term bonds to pursue stable interest income and high trading gains, can be considered to increase the expected return relative to risk.

When investing in foreign bonds, it is worth considering strategies using 'currency hedging.' Recently, interest in U.S. Treasury bonds with excellent credit ratings and high yields has increased, but if the value of the dollar declines, exchange losses could erode bond investment returns. Currency-hedged bond products have emerged to mitigate this risk. However, it is important to note that currency hedging products incur hedging costs equivalent to the interest rate differential between the two countries, which should be carefully checked.

Emerging market bond investments, led by Brazilian bonds, have also been popular for several years. Brazilian government bonds offer interest income exceeding 10% annually on a 10-year basis, with the advantage that both interest income and capital gains are tax-exempt. However, since Brazil’s macroeconomy deteriorated after 2010, significant exchange losses have occurred in the past. Therefore, emerging market bond investments require continuous monitoring of exchange rates and various macroeconomic conditions.

"Interest rates are the gravity of all financial assets." This is one of the famous quotes by Bill H. Gross, known as the "Bond King" in the U.S. It expresses the crucial role interest rates play in financial markets, especially the bond market. This year is marked by geopolitical risks such as "two wars (Russia-Ukraine war, Israel-Hamas war)" and an "election year (including the U.S. presidential election)," along with various variables that could increase financial market volatility, such as inflation trends. Therefore, including bonds as "safe assets" in a portfolio may not be a choice but a necessity.