Private-banking clients and real-money investors, who invest on an outright, unhedged basis, have enjoyed bumper returns this year with base rates and credit spreads both performing well.

With Treasuries close to record lows and the US Federal Reserve easing monetary policy further at last Thursday's policy meeting, rate risk has a greater bearing on performance.

"The risk in credit portfolios is now definitely more on the rate side than on credit side," said Societe Generale analyst Guy Stear. "Currently, in IG credits, two thirds of the return is driven by rate performance and one third by spreads. Rate performance is even more dominant for higher-rated credits."

That is an important dynamic in Asia, where over 90% of this year's record USD95bn of new international bond sales have come from the IG sector, with pricing referenced to US Treasuries. Private-banking clients have gone for an unusually high percentage of those bonds, taking advantage of loans at record-low interest rates to enhance returns.

ICICI Bank's 2018 bonds, issued last month, saw private bank involvement of 14%, well ahead of the 6% when it launched its 2016s last year.

Rising base rates may well result in margin calls for leveraged investors, potentially removing a big pillar of support from the Asian credit market.

Gary Dugan, CIO at Coutts, the wealth management unit of RBS, believes that, if the US Federal Reserve's latest stimulus does achieve some growth, it will come as a big surprise, and yields could easily be up 50bp-100bp, resulting in massive mark-to-market losses for leveraged-credit investors.

"I always tell clients, if you are a conservative investor, continue to invest that way - don't buy conservative bonds and lever up seven times. I think that's the mistake made sometimes in wealth management. Investors don't recognize this and they may end up holding toxic assets when things go wrong."

Betting against growth

The prospects of rising rate risk rattles not just retail investors. Fund managers with mandates to invest on an outright basis are also concerned.

"US Treasury volatility is a major risk for many outright real-money investors as the absolute yield levels are low even though spreads may make sense. If Treasuries sell off, credit spreads may not be able to provide adequate cushion to absorb the shock," said Arthur Lau, head of fixed income at Pinebridge Investments.

Five- and 10-year Treasuries remain close to July's record lows on expectations of further monetary easing from the world's major central banks. If those steps start to have the desired impact, rate risks could become elevated in the medium term.

Some analysts have started to factor in a pick-up in economic growth in 2013, which could see US Treasury yields begin to rise again. That could put IG paper under an additional strain.

"We expect Treasury yields to start rising in 2013, which will divert flows from credit markets as some investors will not need the extra yield pick-up," said Societe Generale's Stear.

"We also see capex beginning to rise, which will make cash flows more negative. Both these trends will put more pressure on credit spreads."

This growing rate risk is already forcing strategists to change tack. Some prefer to cut durations, while others are looking lower down the credit spectrum for additional cushioning from rate-related losses.

Support for high yield

Kaushik Rudra, Standard Chartered's global head of credit research, said US Treasury yields would pose a "real challenge" for credit markets.

"Dividend yields and equity valuations are attractive relative to credit and, if money starts flowing out on the back of an improved economic environment and rising rates, it could pose a real challenge for credit markets," he said.

"We would be more comfortable hedging some of the longer-dated exposure and have been reducing duration to reflect the US Treasury concerns."

A growing preference for lower-rated credits is also a function of this strategy, with Asian primary markets printing two Single B rated deals within two days.

Kaisa Group (B1/B+) and Road King Infrastructure (B1/BB-) attracted total orders of over USD6bn for just USD600m in new bonds.

This also suggests there could be a preference for lower-rated bonds within the IG world.

"The spread cushion against rate losses is thin, especially in high-grade IG," said Krishna Hegde, Barclays strategist.

"A lot of the incremental funds coming in are for IG-only mandates, but we believe they will ultimately migrate to the lower part of the IG market for spread pick-up, especially after the recent rally."

(This article originally appeared in IFR Asia Magazine issue 764, September 15 2012)

(Umesh Desai is Senior Analyst, IFR & Reuters)

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