Next year will still be positive for bonds

Even if the US Federal Reserve raises rates, the long end of the yield curve will continue to rally, says John Woods, managing director at Citi Investment Management.
John Woods
John Woods

Has 2014 been a good year for investing in Asian bond markets?
If you had asked me this question one year ago, we were looking at the fixed-income space with some trepidation. The theme was the Great Rotation, the idea that everyone was looking to sell fixed-income and buy equities.

Which they got half right.
Yes. The market overestimated the bond yield story. This was the incorrect call by almost 100% of The Street. The broad consensus had been extremely negative fixed income.

It didn’t take long for people to realise they were wrong.
I’d say the call became suspect by the first quarter. The short end of the curve displayed an upward bias but the 10-year and the 30-year [US Treasury bond] saw a relentless grinding downward in yields. Global [economic] growth turned out to be a lot less robust than investors originally thought.

So here comes 2015.
And I’m even less certain about the underlying health of the global economy. The eurozone seems on the brink of recession and deflation. Japan is slowing, notwithstanding the high degree of stimulus that’s been thrown at it. China is cutting interest rates; India is under pressure to cut rates. The oil price has fallen off a cliff. All of these things suggest global demand is likely to be subdued.

The US is the exception but is it enough of an exception?
It is undeniable; the US economy is in a much better place. But the best we can look forward to is asynchronous growth and a US [economy] that edges ahead despite the undertow of global deflation. The risk is that the undertow overwhelms the US consumer.

When I speak with equity fund managers about the US, they wax lyrical over the energy revolution. But in bond land, energy companies wrong-footed by oil prices are defaulting. So is US energy good or bad when it comes to Asian fixed-income?
A modest, controlled decline in oil prices is positive for everybody. But uncontrolled, volatile declines in prices are sending a signal about global demand, or the lack thereof.

I don’t suppose we could blame that on those naughty speculators.
The influence of hedge funds is de minimis; global forces far outweigh what they can do right now. Look at the tussle between Saudi Arabia and Opec, between Opec and the rest of the world, combined with slumping demand. That’s the real story, a confluence of a supply shock and a demand shock. Oil futures are still pricing in downward pressure on prices.

So what does this imply for Asian bonds?
Typically, yields in Asian fixed-income of like duration are higher than those found in the US and Europe. That makes Asian fixed-income attractive, and people like it. When you have almost no returns in Europe and low returns in the US, of course investors will hunt for yield. And therefore we’ve seen inflows into Asia. Those flows will continue until US and eurozone yields normalise, or the Asia premium compresses.

What creates that premium?
Banks in Asia continue to face a structural mismatch in assets versus liabilities. The average loan-to-deposit ratio is only 70%, which means Asian banks are forced to buy bonds in order to make up the extra yield they otherwise lose on deposits. This structural bid for bonds in Asia has really been in place since the [1997 to 1998] Asian financial crisis. It’s combined with a cyclical bid for Asian bonds from investors in developed markets. 

Therefore we’ve had a surge in issuance this year and a tsunami of demand, so much so that it is surprising that a bond is issued without being many times oversubscribed almost every day.

What contributes to total returns in Asian fixed-income?
My portfolio is up about 7% year to date. Returns now are less about carry and more about capital appreciation from spread tightening. The underlying bond yields, especially in the five-year space, are reasonably well behaved because the fundamental economic conditions are deteriorating.

I’ve written in FinanceAsia that even if the Federal Reserve raises rates in 2015, it won’t impact Treasury yields, such is the level of demand. Do you agree?
I don’t think it would stop the yield curve from bear flattening, no. My bigger question is, why would you raise interest rates in an environment of increasing deflation?

So you don’t think the Fed will raise interest rates at all in 2015?
I’m very sceptical. But if they do, it might push up the short end [of the yield curve] but the long end will continue to rally. That makes next year still positive for bonds but it requires you to buy duration.

Exactly the opposite of last year’s consensus.
Yes. But today the problem is that duration is expensive. Kexim 10-year bonds issued back in January are now up 10% in total return terms; those bonds are pricing at 108. Duration is rich. The irony is that, across Asian fixed income markets, shorter-dated bonds in the three- and five-year space have higher yields than longer-dated bonds. That’s because prices have risen so much [at] the long end.

So if the duration you seek is so expensive, how do you build your portfolio?
I construct my portfolio to be neutral duration to the benchmark – [the US dollar Citi Asia Broad Bond Index]. It has an average duration of four and a half years. Instead I tend to overweight China, India and Indonesia. I only invest in US dollar-denominated investment grade securities.

If you like China, you must have loved Alibaba’s $8 billion debut issue in November.
I can’t talk about specific companies but the reception globally was obviously positive. It was a large, fixed- and floating-rate, multi-tranche issue. When you see that, it suggests Asian fixed-income has come of age. I wouldn’t have believed you if five years ago you had told me a Chinese company could do that sort of thing in the international bond market.

Is that ‘coming of age’ about Asian fixed-income, or about Alibaba?
I would say Asian fixed-income is not yet seen as a core, standalone asset class by many global managers. Many asset allocators still insist on differentiating Asia’s emerging markets from its developed ones. I look at non-Japan Asia as a single play. Whether you’re comparing Singapore to Indonesia, or Korea to China, it’s a single asset class. I sense Asia’s legacy as an emerging-market story is becoming less relevant for more investors, but the legacy is still there.

As an active manager, that global bias toward Asia should give you some opportunity.
It does provide inefficient pricing. It’s one reason why Asian five-year triple-B names enjoy a 1% spread premium against counterparts in the US and Europe. That premium was flat prior to the global financial crisis in 2007 and I believe it will compress over time. But until it closes, Asia offers value.

What makes China’s US dollar-denominated issues from this year so attractive?
The expectation of a high degree of support for state-owned enterprises.

Which were the issuers.
Correct. Standby letters of credit for many of these issuers have also attracted interest. Although I do remember GDE. [Guangdong Development Enterprises, an investment company owned by the Guangdong provincial government, which went bankrupt in 1998.] Nonetheless, the depth and diversity of Chinese issuance today is extraordinary, as has the appetite for them among our clients.

John Woods, managing director at Citi Investment Management, looks after Asian fixed-income portfolios for Citi’s private banking clients. Based in Hong Kong, he invests in US dollar-denominated investment grade securities issued from Asia ex-Japan. 

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