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15 July 2009
18 July 2009

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JULY 2009

THE RISING RISKS OF LONG-TERM BONDS
The state of California has often been considered a trend-setter for the United States as a whole. But let's just hope that no longer holds true now, because according to its governor Arnold Schwarzenegger, the state has just gone broke: "California's day of reckoning is here. Our wallet is empty. Our bank is closed. Our credit is dried up." Well, perhaps the recent poor demand for US treasuries resulting in an accelerating increase in yields (and accordingly mortgage rates), doesn't really reflect an upturn in the US economy and accordingly less need for investors to seek the safety of treasuries, as the government wants you to believe. Perhaps the reality is just the opposite, i.e. that investors seeking safety for their assets are simply getting increasingly wary of the safety of treasuries and hence are buying less / selling more of them? Sure, we have been saying for a while already that the US finances are in disarray, but hey, we are getting company now not only from Dallas Federal Reserve President Richard Fisher, who estimates the United States unfunded social security and healthcare liabilities to be US$ 99 trillion (yes, 99 trillion and that is on top of the country's national debt), but also from the man actually in charge of auditing the books of the US government for the last 10 years (David Walker, Comptroller of the US 1998-2008). Walker asked rhetorically last month in a Financial Times interview how anyone could still justify bestowing a triple A rating on the United States, given the country's rapidly deteriorating debt and fiscal situation. Even Chinese students have been demonstrating more financial expertise than most industry "experts", as they made headlines recently for breaking into laughter at Tim Geithners assurance of treasuries to be "safe". So, make no mistake, heavy money printing and inflation (most likely going hand in hand with much higher interest rates) is around the corner. Investors should accordingly avoid getting stuck in long-term bonds, which is the asset class most vulnerable to inflation and rising interest rates. This warning would also include the most popular and most highly rated global bond funds typically sold in Hong Kong. Many investors rushed into these after the stock market crash of last year, in a typical ‘rear-view-mirror' approach to investing, which is to chase the asset class showing the nicest past performance chart going up. We instead encourage the use of a forward-looking approach to the assessment of risk and return potential, and to consider purchasing the asset class of best value that has gone down the most (provided the fundamentals are/remain attractive), rather than the one showing the nicest chart. So if you should currently be holding any global bond funds in your portfolio, why not ask your advisor or the fund house for a breakdown of the full holdings of the fund if you have not looked at them before. You may be surprised to find out that some of the highest rated bond funds out there would typically include long-term California state debt and similar niceties destined to be the next sub-prime. (Remember, sub-prime was AAA rated and looked nice on a past performance chart too…) Clearly, inflationary pressure are growing, and we are witnessing at the same time an accelerating West to East economic power shift with a clear decoupling trend of China from the United States. With one eye on real value and the other on inflation we do now recommend exposure to commodities, selected China/emerging market equities as well as Asian convertible bonds (short term Asian corporate debt with conversion right into equities) within investment portfolios. Whilst we do not advocate investing in traditional bonds, especially long-dated ones, we do recommend investors to consider an allocation to Asian convertible bonds. This allows investors to take advantage of the still-attractive corporate bond spreads of Asian companies, in a strategy less volatile than equities, yet with a good upside potential and limited inflation and interest rate risks. Newcomers to the investment world often ask what convertible bonds are, i.e. whether they are bonds or stocks. The answer is that they are a hybrid between those two, namely short-term corporate bonds that – as the name implies - can be converted by the holder into common stock of the issuing company at a fixed price. At this moment in time, where it is uncertain whether we might first see another deflationary market correction after the recent rally, or whether the China and Asian markets will continue to rise further without pausing, convertible bonds are a rather attractive asset class. This is because, on the one hand, they have the benefits of debt instruments in that they pay fixed coupons and are redeemable at maturity. On the other hand, the embedded conversion option provides the investor with participation in the upside potential of the underlying equity, thus offering the bond holder a ‘best-of-both-worlds' option. At maturity, the convertible bonds are worth the higher of (a) their redemption value or ‘bond floor' or (b) the market value of the underlying shares. Convertible Bonds are hybrids between short-term interest yielding bonds and equities On the downside, convertible bonds, like ordinary bonds, would still be subject to the issuer default risk. They also tend to be more volatile than ordinary bonds, while they would underperform equities in a strong bull market. But with the balance sheets of many Asian companies in solid shape, and with significant capital appreciation potential of Asian equities remaining at these levels, the hybrid asset class of Asian convertible bonds does in our view offer an attractive risk/reward trade-off at this time. Investment Committee Tyche Group Ltd

Do you have any comments on this issue? Or topics you would like to see covered in future issues? Would you like us to e-mail Market Truth to you every month? Please direct all enquiries to: contact@tyche-group.com

This newsletter is intended for information purposes only and should not be regarded as a substitute for professional financial advice. Tyche Group Limited shall not be liable for any pecuniary loss arising from the use of any information provided herein.

Wednesday, 15 July 2009, 18:15 registration for 18:30 to 20:00
Saturday, 18 July 2009, 13:45 registration for 14:00 to 15:30

Podium Floor, at the Central Plaza Executive Club,
Central Plaza, 18 Harbour Road

TYCHE HALF-YEARLY REVIEW

We had stated in our January 2009 newsletter “Whilst sovereign bonds of developed countries were the best performers in 2008, emerging markets and commodity-related equities were amongst the worst. We may now see investors coming out of sovereign bonds again and going back into various emerging market and commodity sectors because they offer more attractive value and inflation protection.” Well, that’s basically what happened… and the bounce-back that we have seen in commodities and equities lately, particularly in Q2 of 2009, actually turned out to be almost as breathtaking as the collapse of 2008.

Very interesting is also to witness how in the first half of this year China in particular has emerged with incredibly good economic numbers. Just looking at the motor vehicle industry, it is rather amazing how China has not only overtaken the United States as the world’s largest car market for the very first time, but that it is currently witnessing an unprecedented boom with 2 months waiting lists for the most popular brands. Meanwhile the same industry in much of the rest of the world remains somewhere between free-fall and paralysis (sure, the Chinese government is helping with incentives, but most other countries are too).

Tough times propagate excuses however, and this downturn has inspired the creative genius to levels not seen since the battle of Julu in 207 BC when over 200,000 Qin soldiers were defeated by 30,000 Chu rebels. We’ll look at some of the best and provide some key tips on surviving budget deficits.

So to the billion dollar question: “what to expect next?” Will the West-to-East economic power shift accelerate? What is the outlook for the RMB? Is the financial crisis over, or does the next disaster just lurk around the corner to bite when many thought it was safe at last? What will be the worst value / highest risk asset classes going forwards, and where are the areas of best value / greatest certainty? What is the interest rate outlook and will we see deflation or inflation?

Please join us at our July seminar, presented in English by Stephen Gollop (CEO) and Martin Hennecke (Associate Director) for the answers to all of the above and more! As always, we aim to make our seminars as interactive as possible, with questions from the audience most welcome.

Our seminars are often oversubscribed, so please register early for you and your friends to avoid disappointment. Please register in any of the following ways: phone (852) 2525 3639; fax (852) 2525 3679; or e-mail seminar@tyche-group.com

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