Bourse Securities Ltd
The European debt crisis continues to roil financial markets, as once again Greece's economic crisis is taking its toll on investor confidence. In recent weeks, the threat of Greece exiting the European Union was magnified by the country's political instability and deteriorating fiscal position, resulting in heightened uncertainty. The risk of the Eurozone's crisis derailing the global growth efforts was highlighted in the Organisation for Economic Co-operation and Development's June 2012 Economic Outlook, which identified the Eurozone's debt crisis as the major threat to the global economic recovery. Given the recent erosion of investor confidence, financial markets are bracing for an expected spike in volatility until Europe's debt crisis is addressed with an acceptable long-term plan. As discussed in last week's article, international financial markets are expected to remain turbulent in the near term as a result of the deepening of the European debt crisis. As such, in this piece, we will review the performance of the major asset classes during times of volatility, before suggesting some ways investors can prepare for the expected market turbulence.
The risk/return trade-off
Loss of investor confidence and amplified uncertainty usually leads to heightened volatility in the international financial markets. However, the extent to which assets are exposed to sudden price changes varies across asset class, geographical and sectoral allocation. Generally riskier assets, which traditionally have the potential for higher returns, are more responsive to changes in investor sentiment. The trend of higher risk assets being more prone to price changes during volatility is illustrated in the performance of equity markets across the globe during times of market turbulence. For instance, the loss of investor confidence following the credit downgrade of the United States and the continuation of Europe debt woes in mid-2011, was reflected in the oscillation of international equity markets during the latter half of 2011. As Figure 1 illustrates, the MSCI Emerging Market Index, was subjected to greater volatility than the Standard and Poor's 500 Index. This highlights the trend that during times of market volatility, there is a flight to quality as investors move to safe haven assets. Fixed income instruments, which are viewed as less risky than equities, are usually subjected to less volatility during market turbulence, as illustrated in Figure 2. In fact, since 2010, the global bond market performed favourably and experienced positive returns relative to equity markets. Thus, while the returns on fixed income instruments may not be as alluring as the potential returns for equities, on a risk adjusted basis, fixed income instruments can provide relatively attractive returns for investments.
Stability amid turbulence
During times of volatility, analysts usually recommend investors increase their allocation of fixed income assets and cash holdings, as compared to equities. In turbulent times, "cash is king." Investors, who are extremely risk-averse, can avoid aggressive investing and increase their holding of cash. Fixed income instruments can provide investors fixed, steady cash flows and baring default, principal is repaid at maturity. Also, by holding the bond to maturity, any price changes during the life of the bond will be irrelevant. Bonds can also enhance an individual's portfolio via diversification benefits. Investors can take advantage of further diversification by investing in sovereign bonds and across different corporate sectors. Given the recent increase in market turbulence, investors should consider high quality, investment grade bonds, with a low duration.
Choosing the right fixedincome instrument
For those investors who are looking to take advantage of the current pricing available in the international markets, some sovereign bonds are a relatively safe option. Sovereign bonds, domiciled in emerging markets which possess relatively low default risk, are suitable for risk averse investors. In particular, emerging nations with buoyant economic growth, low fiscal debt burdens and a mass of foreign reserves are preferred. These domestically-driven economies may be less susceptible to contagion effects of Europe's debt crisis. Based on these countries' growth prospects, the inherent strengths of their economies should support their resilience to any slowing of global growth. Corporate bonds are also among the suitable alternatives available to investors with a slightly higher risk tolerance. Debt issues from corporations with strong profit margins, low debt levels and solid balance sheets can be considered. By staying within the investment grade space, investors will benefit from selecting assets with good credit quality. International investors, who wish to take advantage of the fixed income opportunities, can acquire these fixed income instruments from several licensed investment firms, such as Bourse. These bonds can be held to maturity or sold for market value in case of unanticipated need for US$ cash. Investors are urged to ensure the chosen investment firm has access to the quality and depth of research to give suitable guidance in the selection of bonds.
Conclusion
In times of heightened uncertainty, fixed income instruments provide investors with better opportunities for predictable returns. While the corporate and sovereign bond markets may not be totally risk-free, they are an attractive alternative to the oscillating stock market and should be favoured by investors seeking to minimise risk in a volatile environment.
