Short-Term Quality Bonds: An Alternative for Interest Income?

Bank term deposit returns could lose out to inflation; prepare early in response to rate and market uncertainties
Investment-grade short-term bonds offer attractive yields with relatively low volatility and default risk
Focus on defensive sectors, diversification

HIBOR plunged last month, dragging HKD term deposit rates lower. While HIBOR remains subdued into June, lending rates have shown signs of stabilisation, albeit the outlook remains uncertain. Since funds parked in banks could lose out to inflation and see their purchasing power eroded, income-focused investors will likely need to seek alternative options.

In May, the one-month HIBOR plummeted to approximately 0.59% by month-end from 3.98% on 2 May. The decline was largely driven by ample liquidity, boosted by substantial southbound and global fund flows into Hong Kong equities, as well as fundraising activities related to IPOs. Another contributing factor was that the USD's status as a safe haven was being tested, undermined by inconsistent policy signals from the US administration. This drove some of the funds into Asian markets, strengthening regional currencies including the HKD. Under Hong Kong's linked exchange rate system, a strengthening HKD triggered four rounds of HKMA intervention, during which the authority sold HKD and bought USD to ease the HKD strength as the currency hit the strong-side convertibility undertaking of 7.75.

A plunge in HIBOR has prompted some investors to turn to property as a potential investment. However, monthly mortgage payments should only be one of the many factors considered when considering real estate opportunities. Furthermore, with signs that HIBOR is stabilising in June, it is uncertain how long rates will remain at current low levels. Others may consider dividend stocks. Yet, before investing, it is critical to evaluate how market volatility could impact this asset class and whether the risk aligns with one's investment profile.

With the US labour market staying resilient and inflation still elevated, markets expect the Fed to put rates on hold over the coming one to two months. At this moment, investors seeking a sustainable stream of steady income may consider quality short-term bonds, which offer compelling yields with low volatility.

Short-term quality bonds offer compelling yields with low volatility

Investment-grade short-term bonds are supported by robust fundamentals and relatively low default risk. Select European, US, and Asian dollar bonds are offering appealing yields of more than 5%. Since interest rate movements and bond duration have a direct impact on bond price volatility, short-term bonds stand out for their low sensitivity to rate fluctuations. This makes them less volatile and more stable in performance. We particularly favour bonds with a duration of approximately one year. Furthermore, short-term bonds have shorter maturities, which is conducive in assessing the issuer's operational and financial health. This in turn, helps mitigate credit risk. Provided the issuer does not default, investors who hold these bonds to maturity can expect to receive both principal and coupon payments. Interim price fluctuations are typically temporary. Should the bond market perform well and credit spreads tighten, investors may have the opportunity to sell their holdings before maturity for capital gains, further enhancing overall returns. Some actively managed bond funds in the market also subscribe to bond IPOs, which are often issued at a discount. This provides an opportunity to generate alpha.

In addition, issuers of short-term bonds span an array of sectors, offering investors flexibility to adjust portfolios in response to market conditions and seek diversification. At present, we can focus on domestically driven sectors such as the banking, financial and service sectors which are more defensive in nature, while steering clear of export-oriented manufacturing that may be exposed to tariff-related risks.

While HIBOR remains at subdued levels for now, its outlook is unclear. Savvy investors should be proactive in seeking alternatives that can put their cash to use, aiming to generate stable income amid ongoing market uncertainties, and capitalising on the potential for capital appreciation.