Where is your credit research focused - on the high grade or the high yield side?
It changes depending on where the action is, but in general it's fairly well spread across the credit spectrum. My group covers sovereign credits and we also have a credit research department that looks at high grade, high yield, and special situations.
How many people in the team in total?
In distressed research we have two, in corporate credit we have six, and in my team (which covers both local market as well as external sovereign debt) we have four, and in addition there's an economics unit of seven people.
In 1998 we decided we wanted to cover sovereign external debt with the same team as the onshore market. Market structures were developing and we saw that the Asian bond market was actually becoming an 'Asian' bond market. We saw some synergy in having local market coverage, not only dovetailing this, but having it handled by the same group as the external debt coverage. That worked out very well for us in retrospect.
Do you have people on the ground or in Singapore?
We have people based in Singapore and Hong Kong, and we are experimenting with the idea of putting people on the ground in local markets as well.
So you've put sovereign credit and rates together?
Exactly, and if you look at the way Asian markets are developing it's more and more important to look at the whole market and not one segment. This gets us into the subject of the Asia bid.
When we see pricing that we don't agree with on a fundamental basis, we have to start from the assumption that the market is correct, and we try to look at things from the perspective of the dominant investor. A common misconception in the previous interviews with fixed income research analysts, appears to be that there is something irrational about the Asian bid from onshore investors. That couldn't be further from the truth. Onshore investors we speak to in the region, from Korea to Indonesia, are very sophisticated and know what they're doing. What analysts who cover these markets are missing is the perspective of the local market investors, their motivations, and what they are able to do.
The trends that have happened across the Asian debt market have really been driven by changes in the structure of the market and the regulatory environment. And that's why it is important to cover not only the credit aspect of it, but also the market development aspect of it.
Let's take a concrete example. In previous conversations with your counterparts, they have expressed bemusement about the Korea-Malaysia sovereign spread differential. What's your view? Why do you think it is not irrational?
There are two points to make about Korea versus Malaysia, and by the way this is one of our most forceful calls since November last year. We said investors should be buying Korea and selling Malaysia. We thought that in 2001 Korea would trade significantly and sustainably through Malaysia. We have two reasons for thinking that. First of all we run a quantitative model that tries to assess which way the rating agencies are leaning on different credit ratings and also why. In the process of forecasting the direction of ratings pressures on sovereigns, we also attribute the strength of the rating to different factors. Last year was not a year that rewarded a country like Malaysia where a lot of its creditworthiness rests on its export sector. The real strength of the Malaysian credit rating is its export to GDP ratio, debt service to exports and so forth. So last year was clearly not going to be a year that the market was going to reward that characteristic, and so on a fundamental basis we preferred Korea over Malaysia.
But the issue you are really asking us about is the technical aspect, and we picked up on this in 1998 when the Korean external debt and onshore market became linked by FX market liberalisation. From that moment forward, it became possible for onshore investors to buy offshore paper and create a synthetic Korean won security and for offshore investors to do the opposite trade and buy the onshore paper and swap them into dollars as a substitute for Korea 08's. At different points in time this relationship has gone in both directions. During the Daewoo crisis we saw foreign investors buying onshore paper and swapping it into dollars. Then the reverse transaction has been popular in 2001. Anyone covering the market at the time that foreigners were swapping won paper into dollars should have known that that trade could go the opposite way, and in fact it did.
People make the mistake of comparing the Korea 08 to the Malaysia 11, and look at that slope being in the order of 130bp and forgetting about the fact that the yield curve is also very steep. So, for starters, in terms of measurement, you have to be careful and compare asset swap levels with asset swap levels to get a pure indication of the differences in the credit curves. We think that on an asset swap basis Korea should be around 50bp over Malaysia on a fundamental basis. Admittedly it is wider than that now. However, we're not recommending investors to reverse the recommendation we made at the beginning of the year, simply because we think that spread is going to trade very directionally going forward.
Our overall view on credit spreads in emerging markets is somewhat bearish. So given that things could happen in Argentina and there is a great deal of uncertainty about the demand situation out of the US, we think that if spreads widen, Korea will continue to outperform Malaysia. The reason is that there is not a direct linkage between onshore and offshore liquidity in Malaysia. The onshore liquidity, which the onshore authorities can control, cannot come to the aid of the offshore debt market as easily as in Korea's case. There is no liquid asset swap on Malaysian paper.
We think there'll be a bid for Korea when the offshore spreads widen - from onshore - that won't necessarily be there for Malaysia.
One of your major competitors was very complimentary about your treasury and derivatives people in Korea, saying they were structuring some clever trades. Does this mean you are in a better position to have the inside track on some of the technicals?
Absolutely. Deutsche deserves its reputation for creativity in meeting specific onshore client demands, not only in Korea. Just as an indication of our involvement with onshore investors, I am spending the weekend in Korea at a retreat with most or all of our fixed income clients. Yes, Deutsche Bank is dedicated to being a significant player in the onshore market and that's part of my coverage responsibility. Naturally, I have some access to information on how onshore investors are motivated since they are the most important part of our client base. That's actually another of the great strengths of our structure here.
In terms of the interest we've seen from investors this year, Korea has obviously been a big part of the overall Asian pie. So getting Korea has been very lucrative.
That's absolutely right. But then again, it's a huge market, with a relatively liberal regulatory environment, lots of development and new products trading, and a sophisticated investor base.
Are there any other good calls Deutsche has made?
Staying with the market-dynamics aspect, and how the structural changes in markets creates financial flows that affect spreads, the recapitalization bonds in Indonesia are another call. Once upon a time the Indonesian banks had a disincentive to unwind their position in the recap bonds, creating liquidity from them to buy back their external exchange loans. When the Indonesian authorities allowed the Indonesian banks to create what they call staple bonds, that removed an accounting disincentive for them from liquidating these recap bonds. Then from that point forward, the onshore liquidity could flow offshore to then support the exchange loans in a very similar way to the fx liberalization supporting Korean offshore spreads. That bid from onshore Indonesian banks caused the exchange loans to converge to sovereign credit spreads and that was a very big move and continues to be supportive of Indonesian spreads.
In addition to that we have been very real time on giving people target levels in Philippine debt. We have a quantitative way for assessing the correct level of spreads the market will diverge from on a temporary basis but tends to converge to when special factors, special influences move either way, so we've been very good at giving investors target levels for, say, post-Estrada crisis levels that emerge on Philippine debt. Also, William Oswald, our strategist on that market, has consistently had a brilliant call on the effect of onshore market dynamics on external debt spreads, and this has often been a crucial factor.
We also recommended that investors buy Thai sub debt against the sovereign, based on the change in climate there and the new administration. I think we caught the tightening move on sub-debt relative to the sovereign default swaps fairly well.
Another issue we have addressed is that there has been a difficult decision on whether to go high grade or high yield. We've generally advised our clients to remain defensive rather than scale up on their risk into the high-yield, high-beta sector. But no matter which way you were positioned it has been a very tough year for you, from time to time. So increasingly we're inclined to tell clients to take risk within each of those sectors, but to stay generally flat beta against their benchmark - if you see what I mean. There is enough money to be made trading Korean sub-debt against other high yield paper like the Philippines or Indonesia, and money to be made trading Korea against Malaysia and Hong Kong against China, without having to take huge market exposure by trading say, China against Indonesian exchange loans. We will always provide a market directional, and implicit portfolio beta recommendation. But bond portfolio managers should take a lesson from studies on equity market performance that show how difficult it is to increase your Sharpe ratio by timing the market. It is inherently difficult, and even more so in illiquid markets.
Are there any interesting trends you're seeing?
The Asian bond market is becoming much more an 'Asian' bond market and the linkages across markets is becoming more and more fluid. In fact we've seen what used to be traditionally FX investors begin looking at credit markets as a more cost-effective way positioning against particular countries. So it is becoming more and more important to have a grasp of the way all the pieces fit together. Eventually we'll have more and more liberalization and all the markets will be perfectly linked - and whether we are talking about bonds in dollars, won or ringgit there will be some sort of relationship. In the past it hasn't been as important to be aware of these linkages.
