Not to be tarred with the EM brush: Asian bonds outlook 2015

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Investors in Asian bonds look set to benefit from the significant progress made in Asian economies, and more specifically bond market growth, which has led to attractive risk-adjusted returns and strong potential diversification benefits, setting the asset class apart from emerging market (EM) bonds generally.

In a nutshell:

– Asia exemplifies that not all emerging markets have evolved equally.
– All major Asian countries have graduated to investment-grade, marking a significant shift compared to 10 years ago.
– Asian debt attractions include greater diversification and higher expected risk-adjusted returns.
– Expected credit spread compression and higher yields should cushion the impact of US rate hikes.
– Negative China headlines and slower growth has resulted in monetary and fiscal support.

While for many other emerging markets, the outlook is for weak growth, Asia is benefiting from lower commodity prices, ample currency reserves, monetary and fiscal flexibility, stable and improving credit ratings, and a growing middle class helping economies to rebalance by increasing domestic consumer demand and increasing global competitiveness.

Asia has led the global recovery and evolved as an investment opportunity

Quantitatively speaking, at the end of 2014 the Asian US dollar bond market was more than 10 times its size  in 2000. Asian economic growth has far outpaced that of other economic blocs, including other emerging markets, and by 2050, five of the top-10 countries in the global GDP rankings are expected to be Asian (see exhibit 1 below). Trading volumes in Asian bond markets have increased by a multiple of almost 50 in the last 20 years, supported by corporate and government issuance and government initiatives to develop Asia’s bond markets. Demand from central banks, Asian institutions and local retail capital as well as foreign inflows seeking higher risk-adjusted returns have supported the asset class. Asian sovereign credit ratings have been reinforced by robust credit fundamentals; we note from Moody’s, S&P and Fitch that Indonesian and South Korean credit ratings have increased by eight to nine notches since 1998. Since 2008, there have been 10 times more downgrades of bonds issued by entities domiciled in western Europe and other emerging market blocs than have occured in Asia during the same period. In our view, this stark contrast is nothing short of extraordinary.

Exhibit 1: Top 10 economies by Gross Domestic Product at current prices in US dollar terms

Top 10 economies

Source: Citigroup, IMF, BNPP IP, as of June 2014


Asian bonds: Particularly attractive in this low interest rate environment

The superior risk-adjusted return profile of Asian bonds has been attracting investors as they seek higher yields, greater diversification and more stability. From August 2010 to August 2015, the HSBC High Grade Asia Dollar Bond index recorded a high Sharpe ratio of 1.3, superior to that of most other bond and equity indices over the same period. The overall yields now exceed those of most developed countries and investment-grade Asian bonds are now yielding similar levels to European high-yield issues, while their volatility has been significantly lower. Furthermore, the correlation of Asian bond performance with that of many developed bond and equity markets has been relatively low, making Asian bonds a source of potential additional returns and diversification for global investors. We believe that strong fundamentals, including robust foreign exchange reserves, low debt-to-GDP ratios, structural demand for Asian bonds and credit rating upgrades have added to the international appeal of Asian bonds.

Comparing Asian bonds and emerging market debt

Asia accounts for more than 50% of emerging market GDP and more than 75% of the growth in emerging markets, while the benchmark index, JP Morgan EMBI Global, has only around 25% Asian exposure. When comparing Asian bonds to broader emerging market bonds, the first thing to look at is the growth outlook for these regions. According to IMF projections, Asia is forecast to benefit from higher growth compared to central and eastern Europe, Latin America and the Middle East and North Africa (MENA) over both the short term and the longer term (see table below). Secondly, Asian bonds have historically been less volatile in times of market downturns relative to EMD as a whole. Asia is a net oil importer so it is favoured by lower oil prices, while other emerging market blocs are commodity exporters. Consequently, investors in Asian bonds stand to benefit from the stronger growth in Asian countries. Structural demand can be expected to remain strong, given the large accumulations of currency reserves by many central banks.

Exhibit 2: IMF GDP forecasts


Source: Bloomberg, IMF World Economic Database, as of July 2015


As well as the strong global fund flows into Asian fixed income, the asset class is well supported by local investors’ participation across all categories – mutual funds, financial institutions and private banks. It is worth noting that Asian ex-Japan bank deposits have reached USD 5 trillion, which is twice the liquid market capitalisation of Asian local and US dollar bond markets combined. Importantly, global central bank (CBs) and official institutions (OIs) interest in local bonds has increased substantially since 2010. We estimate that CBs and OIs account for around 30% of foreign holdings of local-currency bonds in countries such as South Korea, Malaysia and Indonesia, while the remaining Asian OIs could account for around 20% of total foreign holdings in countries such as Thailand.

What about the impact of the slowdown in China…

In our view, the slowdown is as expected as China reforms and rebalances its economy and in line with government communication about the new normal growth rate and expected GDP growth for 2015 of around 7% as well as the IMF’s forecast for 6.5%-7% growth. The People’s Bank of China (PBoC) has been proactive in using various means of boosting liquidity as well as cutting benchmark lending rates by a total of 140bp since November 2014 and the reserve requirement ratio (which has been cut by a total of 200bp since February 2015). The central bank aims to cushion the growth moderation, which was a deliberate choice by the Chinese government as part of long-term structural reforms. On the fiscal front, the budget for 2015 has targeted a higher deficit of 2.3%-2.7% of GDP, up from 1.8% in 2014. However, the budget was in surplus as of July 2015, suggesting room for fiscal support in the remainder of the year.

China is adopting a ‘proactive‘ stance in its fiscal policy. Given its low government debt and still high currency reserves, it has significant room for fiscal spending. In late 2014, the National Development and Reform Commission approved a RMB 10 trillion package covering projects such as telecommunication, oil and gas pipelines, the power grid, clean energy and transport. The near-term risk of a hard landing by the economy thus looks low. Fiscal and financial buffers are giving the government sufficient tools to respond and support growth if needed and prevent shocks such as a widespread credit event, a disorderly correction in the property sector or policy mistakes. While equity and currency market volatility could dampen investor sentiment, it does not affect policy flexibility. The wealth effects from equity market corrections have been small as equity investments constitute only 5% of household wealth and accordingly, corrections are unlikely to have a significant macroeconomic impact.

We would like to highlight that despite the negative noise on China, China US dollar bonds have not only produced positive absolute returns so far this year, but have outperformed the overall Asia US dollar bond index.

…and a Fed interest rate hike?

When we look at the last interest-rate hiking cycle from 2004 to 2006, we see that Asian credit spreads were compressed by 150bp. Many expect the Federal Reserve to take a gradual approach in hiking US rates this time around. While US growth momentum has risen, inflation has remained well contained and there is more aggregate debt in the economy. We expect the first increase in the fed funds rate to come in late 2015, allowing credit spreads to narrow and bond prices to rise, as happened during the last rate hiking cycle.

Exhibit 3: Comparison of credit spreads

Asian fixed income

Source: Bloomberg, HSBC as of August 2015

Asian bonds: A good source of diversification

We believe the growth, currency and policy dynamics in Asia provide a good source of diversification for global bond investors. These dynamics may become sources of alpha exploited by seasoned fixed-income managers who take active positions in credit, rates and foreign exchange. For instance, the Indian market offers higher yields and is more domestically driven, while Hong Kong and Singapore are low yielders, but at the same time contain high-quality names that can be suitable for flight-to-safety buyers in a risk-off environment.

From a macroeconomic perspective, the GDPs of Asian economies are diversified in terms of compositions, ranging from consumption-driven economies to export-driven economies. China shows the highest degree of flexibility among all emerging countries in government policy when dealing with the ripple effect of economic stress in developed countries. All-weather portfolio managers see these diverse characteristics as an opportunity to improve the risk profile of the overall bond portfolio and to enhance portfolio returns.  Not only the brighter outlook, but also higher expected returns and potential capital gains should encourage investors to add more diversification to their global portfolios by including Asian bonds.

Distinguished by high rates of economic growth coupled with low debt and other strong fundamentals, Asian economies can be expected to continue to attract investors seeking opportunities in Asian fixed income. Given the historically high Sharpe ratio and the low correlation profile as well as the diversity of the asset class, we believe Asian bonds are a compelling diversification and alpha enhancement tool within a global portfolio.

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