Asian bonds in Sweet Spot

Property | Stella Zhai 21 Oct 2019

Asia is a "rare sweet spot" for bond investment with another round of global monetary easing, trade uncertainty and a drop in global investor and business confidence, says Desmond Fu Yunjie, portfolio analyst at Western Asset Management of Legg Mason.

Major concerns for the asset class are currently falling, creating favorable regional conditions, he says.

"There are three main reasons that are supporting Asian government bonds - interest rates cut by the United States, political stability of Asian markets and the low inflation in the region.

"Emerging market bonds become weak whenever the Federal Reserve is tightening," he says, expecting central banks to maintain an expansionary monetary policy in the near term, which will support Asian sovereign bonds to post gains.

The institution predicts the Fed will cut interest rates again in the first half of next year. Fu stresses the move is not due to an economic downturn, but a general lack of business and consumer confidence in the United States during trade war uncertainties.

"The US economy is not exactly slowing down, neither is the global economy," he says, adding that it is structural, not cyclical.

Fu says that despite a slower economy, China's manufacturing industry will feel less impact.

"Companies are not actually fleeing from the Chinese market but are adopting a 'China-plus-one' strategy to expand outside of the country and get closer to their consumer market."

Fu said that a regional block is forming, with consumption concentrated in North Asia, including China, and production transferring to South Asia.

The progressive inclusion of China's domestic bond market in major bond indices will attract sizable passive flows and has a salutary effect on global bond investor appetite, the institution expects.

In September, JPMorgan Chase & Co announced a phased inclusion of Chinese government debt into its benchmark emerging-market indexes from February 28, 2020, which could lead to about US$3 billion (HK$23.5 billion) of inflows into China's bond market each month and ease worries of further yuan weakness, says Fu. He expects there will be lower volatility for the yuan to be in line with the euro for the rest of this year, with the US dollar to continue strengthening slightly.

Asian markets have also featured stable political situations, Fu says, picking out the three largest economies in South Asia - with India, Indonesia and the Philippines all completing their elections with high approval ratings.

Large domestic markets, a build-up of foreign exchange reserve buffers, as well as a focus on government reforms, underpin a secular economic expansion in the three countries, says the institution. For instance, Indonesia has been restricting its fiscal deficit with a fixed upper limit of 3 percent of its gross domestic product, making it a less levered one among emerging markets, Fu says.

The 10-year government bond yields for both Indonesia and India are still holding around 7 percent, enough to offset further interest rate cuts, Fu says.

"Low inflation is everywhere in Asia, which is in line with lower commodity prices. China has been driving up commodity prices in the past 20 years, but is expected to consume less as its infrastructure spending has been reduced," with other Asian economies like the Philippines building at lower costs, he adds.

"It is a rare time for Asia that all these three good things are happening at once, which puts Asia bonds in a nice sweet spot," he concludes.

In terms of valuations, the overall yields of emerging Asia local currency bonds amounted to more than 40 percent during the past five years despite a 10 percent weakness of the related currencies, making them attractive versus US dollar-dominated ones, says Fu.

The institution's Asian Opportunities bond portfolio mainly focuses on "A-" Asian government bonds and local currency bonds, with cautions on corporate issues, especially those by small and medium-sized enterprises amid trade uncertainties. It is underweighting bonds by local government financing vehicles and privately held Chinese issuers.

Fu adds that they are overweight 5-15 year Indian government bond, 5-year China offshore government bonds but more caution for Hong Kong, Singaporean and Malaysian ones.

"We always have close-to-zero exposure in Hong Kong dollar-denominated bonds for our Asian fixed income portfolios due to the lower yield than in US treasuries, and investors have limited access to these bonds," says Fu, adding that Hong Kong government seldom issues bonds to finance the deficits.

That is also the case with Singapore and Malaysia.

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