Asia's leading credit analyst discusses bond strategy

How do you explain the recent surge in Asian US dollar-denominated bond issuance?
The market has become more diversified in terms of borrowers, and the new issue pipeline has become fuller as signs of economic recovery in the region have grown and as investors' risk appetite has also risen. Although US dollars is not the natural currency for financing by most Asian entities, and the usual source of funding is the local bank market first and the domestic bond markets second, the yield spread compression over the past few months and historically low absolute rates in the dollar bond market, has made it attractive for both high-grade and high-yield issuers to broaden their funding sources and their investor base.

How important is the ability of issuers to swap the proceeds back into their domestic currencies?
Some borrowers aim to swap their foreign exchange proceeds back into domestic currencies, but others have a natural requirement for US dollars, whether to pay for capital spending on imported machinery and other inputs, to support overseas expansion, or to refinance US dollar debt.

Why is there so little issuance by Asian names in euros?
We think pricing, including swap costs, has been a factor. At present, the euro-denominated market for Asian names has yet to demonstrate depth as investor demand has focused on currencies that are more readily exchanged into local Asian currencies, especially US dollar issues. However, borrowers have been tapping their domestic markets in large numbers, especially in countries such as Korea and Thailand.

Do Asian borrowers still have to pay a liquidity or any other risk premium compared with similarly-rated US borrowers?
Yes, the credit spread premium over comparable US corporate bonds is still trading at around 90bp. This has gone a long way from the 300bp we saw in the fourth quarter 2008 and the first quarter 2009. But it is still historically cheap: the premium is just 10bp to 30bp in normal times.

The Asian premium has been a reflection of risk appetite. As the latter continues to improve, we expect the Asian premium to narrow further, which means Asian dollar bonds should out-perform US corporate names. A further point is that the implied default probability for Asian paper is still high compared with the past, but economic recovery next year in the region and also in the US, which obviously is the destination of a large proportion of Asian exports, suggests that it should decline. The five-year rates for some high-grade issues are still registering 13% and 15%, yet historically actual default rates have been in the low single digits. This should be another driver for performance for Asian dollar bonds.

What is the prospect for more high-yield issuance following the Adaro, Country Garden and Lumena deals?
It's likely that there will be more bond launches by sub-investment grade corporate names. Better quality credits within that classification, with visibility in cash flow, in flourishing sectors and with more straight-forward stories will be preferred by the market. Investors are clearly less risk averse than at the beginning of the year, but we have not yet seen investors indiscriminately scrambling for issues by companies at the lowest end of the credit spectrum, which we take as a healthy sign of the market.

Which Asian countries' bonds offer the best value?
Korean issues still have the potential to out-perform, despite their spread compression since the beginning of the year. Some analysts have highlighted the supply of Korean names, which have made up around 40% of the total Asian dollar bond issuance so far [this year], and have warned about indigestion. But the fact is, their spreads are continuing to tighten, as investors recognise that five-year single-A quasi-sovereign credits -- such as the Korean state-owned policy banks -- are still cheap compared to Asian or US peers. It's important to stress again that the declining risk premium has been a more important factor determining the performance of Asian bonds.

On the other hand, Hong Kong and Chinese bonds have been relatively expensive, and sovereign names in general offer less yield and so less value than the quasi-sovereigns.

Are there any other trading strategies investors should adopt?
Since May, we've recommended a credit curve compression trade, which has paid off very successfully. And it has further room to narrow. So, we still suggest buying single-B names relative to double-B credits. We have also recommended relative-value trades based on compression of the Asian premium by switching out of tight Asian premium names (like Hong Kong) into those with a higher premium, like Korean bonds. As the market moves on from searching for beta to alpha, credit selection focusing on laggards will gain importance.

Is over-supply becoming a problem? 
Historically, Asian borrowers have raised between $10 billion and $20 billion net each year, taking into account redemptions and coupon payments, but net issuance in Asia has been falling since 2004, and in 2008, there was negative issuance to the market of $14 billion. This year, we calculate that there will be gross payments of $32 billion to investors, so aggregating 2008 and 2009 (and excluding market buybacks by issuers), $46 billion of new supply would be needed just to replenish that short-fall.

So far this year, there has been around $45 billion worth of issuance, so the market has yet to reach a tipping point towards oversupply, particularly within the context of a resurgence of US and European demand for Asian names, supported by the region's rapidly improving economies. The overall technical position is still very healthy.

What are the risks to the recent surge in Asian bond issuance and the market rally?
Liquidity is a major factor and so key risks to watch out for are if interest rates rise or if there is a withdrawal of various stimulus packages, which could have an impact on liquidity. UBS expects the US Federal Reserve to start lifting rates from the middle of next year. The potential backing up of US Treasury yields is also a concern for bond performance, in particular for low-yielding, high-grade bonds. A relapse in economic recovery is also a risk but UBS expects real GDP to grow 2.6% in the US in 2010. In that case, credit spreads should tighten further as credit risk declines.

This interview first appeared in the FinanceAsia Bond Market Guide, which was published together with the November issue of FinanceAsia magazine.

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