Woods: bull, bear or tiger?

John Woods, fixed income research head at HSBC, thinks the spread differential between Korea and Malaysia is all wrong.

Are there any trends in fixed income research that have been prominent in the past year?
Clearly, there have been two dominating trends that have served to exercise the mind, that being Fed easing and the entrenching effect of the Asian bid.
I guess we spent the first quarter of the year trying to discern the relationship and intensity of their respective influences and attempted to position our portfolio accordingly for the duration of the year.
I can't say we were the right way round 100% of the time as so often we found ourselves reverting to the analysis of fundamentals. Very dangerous!
Seriously, the Asian bid has pretty much re-written the investor and borrower profile of the Asian asset class. Valuations are changing perceptions of Asian risk as an emerging market adjunct and this year's phenomenal performance has encouraged high grade accounts to give us a second look.
From my discussions with the buy-side in Europe and the US, there's something of a resigned acceptance towards generic spread levels and the likelihood of this becoming an enduring feature of Asian risk. Poor risk adjusted yields and weak liquidity will be offset by strong total returns and low volatility.
Overall credit spreads have tightened, supported by Mr Greenspan, although this trend has by no means been a straight line. Throughout the course of the year Asia's risk markets have been punctuated with credit shocks which have jerked out yields and pushed investors onto the defensive. Remember we had the long-running Estrada saga, Malaysia's outlook downgrade, Argentine default fears, and of course September 11.
As far as generating research product and ideas, we've leant towards high grade and have been rewarded for doing so. Year-to-date, the high grade component of our Asian Dollar Bond Index has provided total returns of 11.53% against the high yield's 7.22%. Frankly when a bond fund is providing 11%-plus returns to investors, the risk/reward of going further down the credit curve is just not worth it.

What about high yield, for example the Korean banks?
Frankly the sub-debt asset class is off index but it is fair to say that Korean sub debt has performed well - no where near as well, however, as GH Water, which we over-weighted in December last year. We have some Hanvit in our portfolio, but it tends to gap quite aggressively when sentiment weakens and if you're caught the wrong way round it can be quite painful. But actually the size of the bond and the general liquidity is weak.

Some analysts say they find it more exciting to write about sub-investment grade.
Perhaps, but as far as flows are concerned, it's an opportunistic, niche market. By far the largest volume is in the sovereigns and blue-chips. Frankly, the illiquidity of some distressed names makes recovery analysis more akin to an art.
As you know, HSBC is not a distressed asset player; our credit flows are dominated by sovereigns and blue-chips - it's what our Asian and non-Asian investors want to buy. Of course, to the extent that high grade has outperformed high yield thus far, it has paid to do so.

Another view that is emerging is that here in Asia it is very hard to be a pure credit analyst. Technicals play such an important role.

As I mentioned earlier, Asian risk is a typically complex balance of domestic fundamentals; domestic technicals; and exogenous risk factors. You have to get a sense of how all three behave. Often, where there is a strong onshore bid, distressed can trade rich, but even when there is a strong offshore bid, investment grade can trade cheap. Indonesian and Malay risk respectively is a classic example of this.

Ultimately, the mix of pricing dynamics can skew global investors' perception of relative value. In a sense, this is not helpful as it deters liquidity into the region. I guess either the Asian investor is demonstrating they understand a credit better than a global investor and they believe default risk is much lower, or it means that this excess liquidity phenomenon is merely temporary and that ultimately global standards of relative value will prevail once more and spreads will widen. So those are the two forces at work.

Which do you think is the answer?
I think probably the latter. I think this bid is a function of excess liquidity and once that liquidity gets put to work in terms of an uptick in loan growth, this asset liability matching exercise will probably diminish. We'll then start to see a more global balancing of value.

Do you think Korea will be the hardest hit when this happens, and the banks start to act like banks again?

Absolutely. To give you an example, the Korea '08 and Malaysia 11s are trading at a spread differential of roughly 130bp. These two sovereigns are rated the same. In August, Korea reported a current account deficit and we can comfortably presume Malaysia was in surplus. You have a very obvious deceleration of corporate restructuring in Korea and significant acceleration of corporate restructuring in Malaysia. Meanwhile there are bizarre and conflicting signals and policies emanating from both the BOK and MOFE, while BNM and the MOF appear to be co-operating and co-ordinating in terms of a fiscal and monetary balance.

To that extent, I think risk premia are skewed. Arguably, the market has priced in succession risk in Malaysia, but I don't think the market has priced in accurately succession risk in Korea. Kim Dae Jung has to step down next year and I don't think the market is sure who will take his place.

So we have this extraordinary spread differential generated by the onshore bid. And to me it doesn't make a great deal of sense from a relative value perspective. Certainly, it flies in the face of relative value perceptions in the minds of US and European fund managers. And when there is uncertainty about assessing value I guess they feel it is safer to avoid.

What does that mean for you as an analyst when you see what is a patently irrational situation and you want to write in a rational way?

Well, as I mentioned before, I have got it wrong. From a portfolio perspective I started overweighting Malaysia too early. I guess we initially thought this on-shore phenomenon would be short lived and that the market would re-establish some type of value norm. But in fact that didn't happen. I was losing too much from a total return perspective and I had to cut it back, and swing round to a more obvious position. At the moment, I am overweight the higher grade sovereigns and neutral Malaysia and Korea.

You have been candid about being wrong. Are there positions you have taken this year you are proud of?

One or two. I like to think we got out of Indonesia at the right time. We long had the sense that political risk was not being reflected and we took the view that things would deteriorate further. We cut all our Indonesian positions at relatively attractive levels. Shortly after the political instability caught up with the markets.

We called the resignation of Estrada back in October last year and positioned our books accordingly, accumulating quite aggressively at the longer end of the curve in January and made a couple of hundred basis points on that trade at the point he was forced to leave.

We also put out a piece called "Asia's Perfect Storm" in July where we examined gathering storm clouds and decided to turn defensive, so in the ensuing downturn we were positioned the right way round.

Frankly our model portfolio has consistently outperformed our Asian Dollar Bond Index, which is satisfying. When you think about it, an index is a snapshot of every buy and sell decision in the market at any point in time, often made by people with better access to better information than you. Meanwhile, you're the guy trying to outperform all of that. It requires concentration.

How much time do you spend on rating advisory?

This year we were mandated by three first time issuers: Hongkong Land, Mortgage Corporation, and one soon to be announced (Editors note - Jardine Strategic). We've also been involved in a range of issuer specific mandates. Frankly, we've been kept busy in this area and it has been a consistent theme for most of the year. We do it alongside our 'normal' job, so time management is involved.

Are there conflicts of interest in doing ratings advisory?

If you look closely at the exercise, it is possible to identify generic conflicts of interest. But that is true of any bank our size and every bank has their own way of tackling these conflicts. At the working level, we create an 'insiders book' and the person doing the advisory is firmly on one side of the wall and does not communicate with anyone on the other. Ultimately we take guidance from the lawyers; if they're happy, I'm happy.

Does it make your job trickier by the fact that HSBC is very active in the primary markets?

To be honest, I believe I am a better fixed income analyst having been a ratings adviser. And I think I am a better ratings adviser having been a fixed income analyst. The two 'hats' are mutually supportive in giving all customers a better product.

Do you think the spread between MTR and Hutch is too wide?

Yes. The thing is MTR is acutely sensitive to swaps spreads and to the extent we've seen a tightening in swaps spreads since mid-September, asset swappers have been able to pick up MTR at relatively attractive levels. This bid has ultimately distorted MTR's relative valued from a treasury perspective. I guess it's a defensive, insulated type play, at least from a local perspective. Hutch, on the other hand, has concerns over its ports, sea lanes and shipping insurance; it also carries the telco burden around with it, and as a consequence has be penalized. To the extent technicals and fundamentals have caused the spread to blow out, I suspect it will tighten once the safe haven trend among investors eases.

Do you speak to hedge funds?
We speak to a broad range of counterparties.

Are hedge funds a big part of the business?
Not as much as they used to be.

One of your counterparts said that they now take the approach of going to clients and rebalancing their whole portfolio, to enhance the return for the same level of risk. Is that an approach you take too?  

There are two things we do on a daily basis that we believe directly assists our clients. Firstly, our ADBI index, launched more than two years, serves as a benchmark for approximately US$ 500 million in funds partially or completely invested in Asian bonds. The constant re-balancing of the ADBI in terms of new issues and changes in liquidity, we think provides investors with a useful guide to changing investment opportunities.

Secondly, as you know, we launched our Asian Model Portfolio (AMP) late last year in an attempt to more transparently articulate and track our fixed income strategy. The AMP is designed to leverage our expertise in credit analysis to outperform the benchmark index, something most fund managers are mandated to achieve. Actually, the research ideas embedded in the AMP are subject to the same rigor and discipline as a regular fund, and therefore, we believe, most relevant to our clients' rebalancing strategy.

Actually, at the end of this month we also rolling out an Asian Local Bond Index (ALBI) to serve (and hopefully stimulate) growing regional and international demand for a local curreny bond index. Again this type of product, we hope, will improve the profile of Asia's local markets; assist in client's portfolio balancing; and complement its sister index, the ADBI.

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