Asia has not only led the global recovery but also evolved as an investment opportunity
Quantitatively speaking, the local bond market is 45 times larger now in 2013 than it was in 1995 and has more than doubled to USD 6.5 trillion in the five years leading up to December 2012. In terms of GDP, Asian growth far outpaces other economic blocks, including other emerging markets (seeFig. 1). Trading volumes have jumped 44-fold since 19951 as a result of corporate and government issuance to raise capital, and government initiatives to develop this market. Demand from central banks and Asian institution have attracted foreign inflows seeking higher risk-adjusted returns, driven by the needs of the growing consumer class and the rapid development of domestic economies. When we look in greater detail at the repeated upgrades in Asian sovereign ratings in recent times, we see that Indonesian and South Korean credit ratings have moved up eight to nine notches since 1998. Since 2008, there have been 86 downgrades in Western Europe and only five downgrades in Asia during the same period. This stark contrast to the European fixed income market is nothing short of remarkable.
Asian bonds are particularly attractive in this changing investment environment
The superior risk-adjusted return profile of Asian bonds has been quietly drawing investors’ attention as they seek higher yields, diversification and stability. From December 2000 to July 2013, the HSBC Asia Dollar Bond and HSBC High Yield Bond have achieved the high Sharpe ratios of 0.94 and 0.98 respectively2, superior to most other bond and equity indices over the same period. Their yields overall now exceed those of most developed countries: they are well ahead of the 2.5% US 10-year bond yield offered today. Furthermore, the correlation of Asian bond performance with that of many developed bond and equity markets is 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 (FX) reserves, low debt-to-GDP ratios, structural demand for Asian bonds and 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, yet the emerging market universe has less than 20% Asian exposure. When comparing Asian bonds to emerging market debt (EMD), the first thing to look at is the growth outlook for these regions. According to IMF projections, both developing Asia and ASEAN 5 countries enjoy higher growth, compared to Central and Eastern Europe, Latin America as well as Middle East and North Africa (MENA) over both short-term and longer-term investment horizons. Secondly, Asian bonds have historically had lower volatility in times of market downturns relative to EMD. Consequently, investors in Asian bonds clearly stand to benefit from the stronger growth coming from Asian countries. Structural demand is set to remain strong given the cash rich central banks see large accumulations of foreign exchange among Asian central banks.
The prospect of Asian foreign exchange appreciation and demand for higher risk-adjusted returns is expected to lead to an increase in Asian fixed income allocations by global central banks, global institutions and individual investors. 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 the Asian ex-Japan bank deposit base has reached USD 5 trillion, which is twice the liquid market cap of Asian local and USD bond markets combined. Very importantly, we see global central banks (CBs) and official institutions (OIs) interest in local bonds have increased substantially since 2010. We estimate that CBs and OIs account for around 30% of foreign holdings in localcurrency bond markets such as Korea, Malaysia and Indonesia, while other Asian official institutions may account for around 20% of total foreign holdings in countries such as Thailand.
The Asian fixed income market’s likely reaction to a potential Fed interest rate hike
When we look at the last interest rate hike cycle in 2004 to 2006, we see that Asian credit spreads compressed by 150bp3. Given that we do not expect any interest rate hikes in 2014 and believe that the earliest for such a change to the Fed funds rate will come in 2015, we expect that credit spreads should decrease and therefore bond prices should rise as global growth recovers a pre-condition for Fed to start hiking rates.
A good source of diversification
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 FX. For instance, the Indian market offers higher yield and is more domestically driven, while Hong Kong and Singapore are “low yielders” but at the same time contain high quality names which are considered to be “flight-to-safety” places during a risk-off environment. From a macro perspective, Asian economies are diversified in their GDP compositions, ranging from consumption driven models 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 the crisis 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 the portfolio returns. Not only the brighter outlook, but also higher expected returns and potential capital gains should encourage investors to add more diversification to global portfolios by including Asian bonds. Asia remains the strongest global growth block, relative to the 2-4% growth in the emerging markets and approximately 2% growth in the US. Currently, Asian countries represent 20.5% of global GDP and by 2030, this number is forecast to increase to 40.9%4. We think the Asian fixed income market is clearly underrepresented in investors’ portfolios. Distinguished by high rates of economic growth, coupled with low debt and other strong fundamentals, Asian economies will continue to attract more investors seeking opportunities in Asian fixed income. Given the historically high Sharpe ratio and 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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