Safety nets

Asia’s domestic currency pools are supposed to be big enough to protect the region’s growing companies from any turmoil in the global markets. A sell-off in US Treasuries, however, has had a big impact on yields across the region.

Fears of higher interest rates have dominated the fixed-income market over the past few months and prompted investors to keep withdrawing funds from this asset class. No market was spared in the selloff that started in May after Ben Bernanke indicated that the US Federal Reserve might start cutting back purchases of Treasury bonds and mortgage-backed securities as early as this year.

Private foreign investors disposed of US$29bn in US Treasury bonds and notes in May, after selling US$14.5bn in April, according to Treasury Department data. The yield on 10-year Treasuries soared more than 100bp from the start of May to the end of June.

The selloff has caused havoc in Asia’s local bond markets and increased volatility in credit spreads. Indonesia’s local 10-year benchmark spiked almost 200bp in the same period, while the Philippines rate jumped more than 100bp.

“We consider this as a temporary correction as capital is orientating itself around the markets and a few of these markets have different growth potentials,” said Henrik Raber, global head of debt capital markets at Standard Chartered. “Currently, the sentiment would appear to indicate that the US might see faster growth than other regions. Overall, we view this as a temporary situation.”

Much of the adjustments in the Asian local currency markets had been primarily concentrated in the rates market, said Thomas Meow, head of credit markets at CIMB Investment Bank. Foreign investors hold a notable amount of local currency government securities – about 30% each for Indonesia and Malaysia and around 20% for Thailand – and the adjustments in rates have been largely attributed to the repatriation of foreign funds back to the West on an improving US outlook and the impending cutback in quantitative easing.

“Foreign direct investments are still expected to flow into most ASEAN countries, and the real economy continues to grow, pointing to the fact that local economies and markets are still fundamentally sound,” Meow said. “This leads us to believe that current movements are merely a correction.”

Over recent times, QE had become the dominant influence on valuations and investment flows in almost all parts of the financial markets, said Philippe Descheemaeker, global head of fixed-income-product specialists at AXA IM. “The influence of policy goes beyond the government bond market,” he said.

Lower underlying yields had benefited all fixed-income asset classes and the crowding out of investors from government bonds into spread products had led to credit spreads narrowing and total returns from bonds being well above their longer-term averages, he added.

Global asset markets had also been fixated on the timing of the Fed’s tapering of QE, Descheemaeker said. The sharp rise in Treasury yields and corresponding increase in volatility has had an impact on other parts of the financial markets, including the Asian bond market.

“Speculation over the timing of the Federal Reserve’s tapering has seen a partial reversal of asset prices and negative returns from most sectors of the bond market, including Asian bonds,” he said.

The selloff in Asian bond markets, Descheemaeker added, was exacerbated by poor liquidity as market makers appeared less willing to hold inventory in the aftermath of the global financial crisis. The sharp rise in China interbank lending rates and the downgrading of China’s growth profile is also a consideration.

So, is the worst yet to come for the Asian bond funds?

“While the medium- to longer-term outlook for Asian bonds is positive, we believe it will be difficult to extract positive returns in the short term,” Descheemaeker said. “Bond markets are likely to continue to adjust to a more realistic equilibrium, consistent with the eventual redundancy of QE.”

Rapid growth

After the Asian financial crisis in 1997 exposed the dangers of foreign currency funding, there was widespread agreement that Asian economies needed larger and more developed local bond markets.

Asia’s local currency bond markets have grown rapidly and are currently capitalised at around US$6.7trn, up from US$921bn a decade ago, according to AXA IM. Government bonds account for a little over 60% and corporate bonds 40%.

“The local currency bond market is much larger than the established US dollar bond market,” Descheemaeker said. “The region’s bond markets have gained significant attention from international investors looking to leverage the opportunities available in the region.”

With higher integration and foreign ownership of Asian bonds, as well as fluid global liquidity, Asian bonds have not been immune to volatility in global markets.

US dollar bonds from Indonesia and the Philippines had largely been sold due to a repositioning of funds as the outstanding papers had traditionally been distributed to US and EU investors, while the local currency yields had traced their foreign currency spikes with Indonesia moving up in a more substantial manner, said CIMB Investment Bank’s Meow.

“For Indonesia, apart from the high foreign content in ownership, the yield movements were further exacerbated by the rationalisation of fuel subsidies, which has been expected to notch inflation up after a long period of moderate price pressures,” Meow said.

“In the short term, due to some of the macro factors in the economy, we expect to see some volatility around local currency issuances.”

Following the fuel price increase, Bank Indonesia has also taken the pre-emptive measure of hiking rates twice consecutively by a total of 75bp. “This has also served to cement the adjustments to their current levels,” Meow pointed out.

For the short term, AXA IM’s Descheemaeker holds the view that Indonesian Government bonds will trade weaker over the coming months.

“Indonesian local currency bonds have been one of the most vulnerable markets in Asia, consistent with its high level of foreign ownership,” he said. “Weaker commodity prices have also weighed on Indonesia’s current account balance, while inflationary pressures arising from fuel price hikes and a weaker currency are likely to imply further tightening by the Indonesian central bank in the near future.”

Although the HSBC Asian LCY Bond Returns Index showed negative returns during June, Asian local currency bonds remain attractive assets to many. StanChart’s Raber is still very positive about Asian emerging markets. “Given that Philippines and Indonesia have more liquid bond benchmarks outstanding, it is not surprising to see price volatility.”

“In the short term, due to some of the macro factors in the economy, we expect to see some volatility around local currency issuances,” he said. “This is going to be driven by two things – movements in interest rates and currencies. The combination of those factors will be the potential drivers that impact demand for local currency securities.”

Also, Asia’s local currency pools were deep enough to provide the capital needed for companies in the region, Raber added.

“We foresee continued growth in Asian economies and the region’s companies. So, there is a need to continue to broaden the local liquidity pools. As the financial markets grow, the capital markets will deepen,” he said. “The Asian economies will see a great growth trajectory over the coming years and capital flows will adjust over time.”

Fundamentally, the Asian local currency markets will continue to grow as the region’s economies are increasingly moving away from export dependence towards domestic demand.

“For local investors or local issuers, their local markets are their first ports of call for investing and raising capital. This is no different for Asia,” Raber said. “We see local markets as the several safety nets that Asian investors and issuers have. Moreover, these markets will continue to deepen.”

Even though cross-border investments have increased, Asian local currency investors have typically been more focused on investments in their countries of domicile. In South-East Asia, local companies had continued to access the local currency bond markets over the past month, despite the adjustments in the rates markets, said CIMB Investment Bank’s Meow.

“Foreign ownership in local currency corporate bonds is not prevalent and, while foreign investors have been repatriating funds, local investors’ appetites remain healthy, albeit with adjustments in yield expectations,” Meow added. “Although we saw slightly more subdued activity levels in the primary market for Singapore and Indonesia due to the market volatility, it is clear that the ASEAN corporate bond markets will still be open for business.”

So, despite the short-term challenges, the Asian bond markets would still provide investors with opportunities to benefit from the region’s positive long-term outlook, AXA IM’s Descheemaeker said. “Asia’s growing middle class will increasingly drive Asian economies in the future.”

To see the digital version of this report, please click here.