Asian debt returns may disappoint in the short term

Long term, Asian fixed income is the place to be, but in the shorter run, investors should perhaps be more cautious, argues a panel of specialists.

The Asian fixed-income market has seen huge expansion in the past decade -- and that's likely to continue, as fundamentals and growth prospects in the region are significantly better than those in developed Western markets.

However, returns may not match expectations in the short run, and there's some way to go before the debt market achieves the level of liquidity in Europe or the US, argued panellists at the AsianInvestor and FinanceAsia Asia-Pacific Debt Forum in Hong Kong this week.

Asian bond issuance has increased ten-fold since 1996, according to the Asian Development Bank, from $500 billion to $5 trillion last year, says Lim Heong Chye, chief investment officer at APS Komaba Asset Management in Singapore. Lessons have clearly been learnt from the Asian crisis, he adds, but there are a lot of structural changes still taking place that are needed.

One issue he cites is accessibility to Chinese and Indian fixed-income assets. To have access to China, a QFII quota is required, to which some large international investors now have access, but there are a large number still waiting for quotas.

India has done a better job of improving foreign access to its domestic markets, says Lim, adding that his firm has access to Indian bonds, whereas in markets such as Indonesia, Korea and Malaysia such access is not available.

In addition, foreign exchange controls have been significantly reduced in Asia in the past five to 10 years, making it a lot easier to buy local-currency bonds, he adds. And growth in the number of double-taxation agreements means local-currency bonds are proving increasingly popular.

Yet the fact remains that a far smaller proportion of Asian debt is held by foreign investors than the proportion of foreign investors holding European or US debt, says Lim. Between 5% and 20% of Asian debt is held by non-domestic investors, while 50% of US debt is held by foreigners. 

There is a positive aspect to this, he notes, in that there is less risk of a sudden withdrawal of capital by foreigners from Asian debt assets. But the figures also show that there's still a long way for Asian debt to go in terms of attracting foreign investment, says Lim.

As for whether Asian debt is a safe place to be in the current markets, the panellists had mixed views.

Dominic Jooris, Asia-Pacific head of investment-grade capital markets at Goldman Sachs in Hong Kong, says Asian fixed income is less risky than European fixed income and is relatively free of contagion from Europe's sovereign debt woes.

"I will stick my neck out and make the case for decoupling from an investor perspective," he says. "In Asia, you have a solid economic situation. The region may suffer from a global slowdown, but we've seen through the course of the crisis that its economies have continued to perform quite well.

"Generally you don't see any investment contagion for sovereign risk in Asia from the perception of European risk," he adds.

Looking at credit-default swap (CDS) levels -- the cost of insuring corporates or governments against loan default -- European credits were comparatively more stable immediately after the collapse of Lehman Brothers than Asian ones, notes Jooris. Asian CDS spreads spiked from December 2008 to January 2009, signalling major concern over the safety of Asian credits, he adds.

But it didn't take long for the markets to look at the supply of European paper -- such as government debt and government-guaranteed bank paper -- and realise the pricing risk associated with it. And that realisation led to European CDS spreads widening and Asian spreads coming in a lot, particularly in the second half of 2009, says Jooris.

"Over time, the Europe situation will stabilise," he adds, "but it will still remain a riskier area so long as you don't know where the government backstop of the system stops."

Pang Cheng Duan, head of fixed income at MFC Global Investment Management (Singapore), is slightly less sanguine about Asian debt. "There's no safe haven per se, because the world is very integrated and correlated," he says.

However, he says one reason Asian fixed-income assets were battered post-Lehman was the need for hedge funds to withdraw capital to prepare for redemptions. "They saw the big profits they could take [from] the liquid Asian markets," he says, "so they liquidated a large portion of their Asia holdings."

And Pang believes strong Asian fundamentals mean investors will benefit from being in Asian fixed income in the long run, although he advises caution in the short term.

"People have focused on strong fundamentals in Asia, but that doesn't mean you will always see outperformance [in Asian debt] in the near term," he says. "People note that volatility has been high in the recent past, so they take the view that if redemptions are potentially coming, it's better for them to reduce exposure in the near term."

Others are also bullish on the long-term outlook for Asian bonds.

In a report published this week, Deutsche Bank strategist Martin Hohensee says he has a long-term bullish view on Asian currencies that is reinforced by various factors, including structural issues such as Asia's savings and demographic profile, the long-run outlook for fiscal and monetary policy, shifting Asian central bank currency policy, and sovereign credit risk premiums.

"And thus, once the dust settles and markets turn to the longer-term," he adds, "we remain optimistic on the outlook for Asian bond-market returns."

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