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Asian fixed income debate: Looking beyond the carry trade

The Asian bond markets have given investors an easy ride in the past two years. Now, with inflation and interest rate uncertainty, buyers need to be smarter.

Stephanus Turangan, Mandiri Sekuritas (left):
The markets need a fuller range of financial
instruments, particularly repo and derivatives


CL, Euromoney  In the last two to three years, the Asian bond markets have broken all records in terms of issuance and tightness of spreads. But now we have a very different outlook for global bond markets, particularly with the change in the yield curve and the increases in US interest rates. So what are the key issues for the Asian market in this new environment?

TM, CIMB  The two key issues have been the credit concerns sparked by developments in US autos and then inflation. I think appetite for Asian credits will continue but perhaps not at the levels we saw previously. Whenever we did a deal last year, we regularly got six, seven, 10 times book, and the trading accounts were very interested in every transaction. That may be gone. Nevertheless, I think the real money investors will still be around. And I think spreads have come to a level where people are comfortable again.

ST, Mandiri  Sekuritas  My perspective is the domestic markets, since Mandiri Sekuritas is mainly active in local currency fixed income. There, liquidity is still very strong and, though it may be true that the cyclical bull run is over, because of the strong liquidity in the market we may not be affected much by rising US rates until inflation starts to creep up. In Indonesia we have a problem in that as the oil price increases, Pertamina buys more US dollars and causes the rupiah to weaken, causing inflation. This is because oil export proceeds go directly to the government, while Pertamina has to import all of the country's domestic fuel requirements.

LHC, DBSAM  The market really falls into two parts. The first is US dollar-denominated Asian bonds. There spreads have tightened a lot since the Asian crisis and are now close to pre-crisis levels. If you look at the sovereign deals from China, Thailand and Malaysia, they trade at 40 to 60 basis points above the US Treasury. Spreads are tight not just because of real money accounts but also because central banks are buying their own government paper. The exceptions are countries like the Philippines, where spreads are more closely correlated with what's happening in Latin America. And of course the ratings story is important: most of the Asian countries are likely to enjoy either no change in their current sovereign ratings or even a slight upgrade.

The second part of the markets is the local currency-denominated bond markets. In these markets global interest rate movements are less important than domestic economic conditions. Yes, rising US rates can have a large impact on markets such as Hong Kong, but in countries such as South Korea, you can see local interest rates have de-coupled from the US.

CL, Euromoney  Ooi Lay, what would you add?

OLL, GIC  Clearly, post-crisis the markets were primarily driven by local pension and insurance money, asset-swappers and the central banks. However, in recent years, there have been flows from cross-over investors from the US corporate world and, lately, we have seen the emergence of newly set-up hedge funds in major Asian financial centres. All these different buyers have helped to spark greater demand for Asian bonds. And, as long as the credit metrics stay positive, then I think spreads will remain supportive in the near term. Even in the recent sell-off, there was little capitulation because the technicals are good and, because of redemptions, there was money to be put to work. With the high oil price, Middle East money is looking for a home and many of them are known to be looking at Asia as an asset class.

Credit bubble coming?

CL, Euromoney  Has excess liquidity distorted the pricing of assets?

LHC, DBSAM  Well, in markets where there are fewer financial controls – such as Singapore, Hong Kong and Indonesia for example – that may be true. But in general it is the strong economic performance of the region that has attracted the flows that have caused currencies to appreciate against the dollar and led to the criticism of this so-called excess liquidity.  Also, after the Asian crisis, most governments have put a lot of effort into developing their local currency bond markets and issued a lot of local paper. Before the crisis, the ratio between equity and fixed income was about 90/10. Right now in terms of market capitalization, the bond to equity ratio is about 50/50. Creating that local market liquidity has been a good thing and it also attracts foreign investors.

CL, Euromoney  Thomas, you were on the road recently. Have investor attitudes become more cautious?

TM, CIMB  Yes, somewhat. They are a lot more price sensitive.

CL, Euromoney  So spreads will tighten?

ST, Mandiri Sekuritas  Well yes, compared to six months ago, but against that you have a better credit story than six months ago. This is especially the case in Indonesia – with better political leadership, higher economic growth and a rational government budget. These should all translate into a better credit outlook for the sovereigns and major corporates.

CL, Euromoney  So it sounds as though it is a tricky time to be thinking about getting into the market?

LHC, DBSAM  Well, it depends on which part of the credit curve you're looking at. In the US and the US dollar then it's true that in the autos and consumer sectors spreads went out quite substantially at the triple-B part of the curve, while at the single-A/double-A part,spreads held. So there is a definite shift into safer sectors, and that will favour Asian sovereigns and to a lesser extent financials.

OLL, GIC  Investors have got to work smarter now. The key to making money going forward is to not just throw the baby out with the bath water and retreat completely because the easy carry trade is over but to use your skill as a manager to be credit selective and trade both ways. On the intermediary side, the challenge is to create more tailored products to suit specific investor profiles

CL, Euromoney  You mentioned that liquidity overrode credit concerns and interest rate issues in Indonesia. But what is the credit cycle in that country?

ST, Mandiri Sekuritas  Liquidity is very important, but I think Indonesia has the potential to get to investment grade. In the private sector, companies have lower gearing ratios and debt levels and are re-financing at lower rates. At the sovereign level, the economy is improving, and the oil price helps. So, we think there is potential for upgrade. Longer term, credit will continue to be sought for its yield pickup – given money-market rates that are low even adjusting for the recent rise in inflation, which we think is still benign.

CL, Euromoney  Thomas, what about the situation in Malaysia?

TM, CIMB  Well, the bond market in Malaysia has been driven by liquidity since the government lowered interest rates to the current level. A lot of real money investors – insurance companies, pension funds – are finding yields too low and are looking at less liquid investments and moving out along the maturity curve, as well as down the credit curve. They are also increasingly looking at structured products. In Malaysia, liberalization is intensifying: exchange controls have been relaxed. As yet though, because of strong local market conditions, investors are staying in the domestic markets, but looking for more duration and credit plays.

Intervention is driving markets

CL, Euromoney  A key trend has been central banks managing their exchange rates relative to the US dollar. What effects has this had?

OLL, GIC  For an example of how liquidity is a driver, look at the Korean local bond market at the beginning of this year. Secondary market bond yields were negatively impacted by the perception of a huge supply of monetary stabilization instruments after the heavy currency intervention by the government.

CL, Euromoney  And what about the euro? Are Asian governments – and for that matter, issuers and investors – looking more at the euro? There have been pioneering issues from KDB and China.

LHC, DBSAM  Yes, we are detecting growing investor preference for Asian bonds denominated in euros. That is partly of course because of the currency losses they've experienced on their dollar holding in the recent past. They therefore want to diversify and not just into the euro, but also into the yen and maybe local currencies.

CL, Euromoney  Stephanus, do you think Indonesian issuers would be interested in moving in this direction?

ST, Mandiri Sekuritas  Not in the short term, but I agree that investors want diversification and are concerned about dollar volatility, the budget deficit and rising rates. In Indonesia, the issuance of US dollar-denominated bonds in the last couple of years has been driven by Indonesian investors taking about 60%, 70% of the issuance. They are not comfortable with the euro yet. This is mainly because most offshore trade and financial transactions are denominated in US dollars. Even Japanese companies repatriate their profits in US dollars not yen.

CL, Euromoney  Is there a conflict here between issuers and investors? Issuers like issuing in a depreciating currency; investors don't want to buy one.

TM, CIMB  That's true. But issuer behaviour is not driven by that alone. Their decision is also influenced by where they can actually access funds at a particular time. High-grade issuers who need substantial amounts of financing may want currency diversification. These issuers have more flexibility as they have access to the swap markets to manage their currency risks separately. In other cases, most of the issuers' business is in dollars, is denominated in dollars. So there is no need to move quickly into euros.

CL, Euromoney  Ooi Lay Leng, you invest on a global basis. What would you prefer to see in terms of currency diversification?

OLL, GIC  In most of my portfolios, the currency bet is taken separately. So, if I like euro assets, I buy them, and the currency view and hedge is put on elsewhere. I have been quite disappointed in emerging market euro-denominated securities so far. Not only is there not much issuance, there is also less liquidity in the issues that have been done, compared to similar names in US dollars. Now that is not just an Asian story – look at Brazil in dollars versus Brazil in euros – it is just a fact that emerging markets has traditionally been a dollar issuance domain. I think more could be done by the banks to sponsor euro issuance and liquidity but right now if I want an allocation to euro, I make it in the other asset classes rather than just in emerging market bonds (especially for high-yielding names).

ST, Mandiri Sekuritas  There are secondary market liquidity issues in the local currency markets too.

OLL, GIC  For example, in Indonesia, because of its recent debut in both the local and international bond markets space, everybody is usually on the same side when investing and, when times are bad, dealers are loathe to hold the securities given the low credit rating of the country.

Lim Heong Chye, DBSAM: The MAS has put a
lot of effort into developing the secondary

ST, Mandiri Sekuritas  In a bull run, it's hard to find any offers and it's always a one-way street when the market is turning. This is because the corporate bond market has recovered only in the last two years and government bond trading also only started two to three years ago. We have enjoyed low inflation and declining interest rates. The adjustment in these is rather new to this market. OLL, GIC  Hence the central bank had to come in and buy back the bonds from the secondary market to stabilize the situation when there was a recent mark-to-market scare followed by massive bond fund redemption in the rupiah government bond sector.

CL, Euromoney  Are you seeing the same thing in Malaysia?

TM, CIMB  In Malaysia, secondary market volume has been growing quite well but, because there is so much money looking for assets, issues tend to be held tightly as investors worry that if they sell, they will not be able to find sufficient bonds to reinvest in. So prices are not always available from the market-makers.

CL, Euromoney  So, how do we get to the next stage – where the local markets have deeper liquidity?

ST, Mandiri Sekuritas  One thing the markets need is a fuller range of financial instruments. The cash markets need a functioning repo market. They need derivatives markets and structured products. We also need better regulation. Then market-makers will find it easier to make two-way prices. And I think we need more investor education. In Indonesia, spreads tightened so fast because of the growth in the mutual fund market that went from US$2 billion to about US$12 billion market in just three years. But as soon as there was the possibility of a rise in US interest rates, US$2 billion left the market almost overnight. Now in those circumstances it is difficult for market-makers and fund managers to operate and we need investors to be better  educated so that they are less volatile in their investing behaviour. This is because investors are just beginning to move money into longer-dated instruments and are not really ready for the turning point in inflation and interest rates.

New products needed

CL, Euromoney  What lessons can these less developed markets learn from the more mature ones like Singapore?

LHC, DBSAM  Well, obviously the MAS has put a lot of effort into developing the secondary market, and the market-making mechanism has improved quite a bit. The swap market in particular has been a great success. Another factor to look at is tax and the MAS came up with a lot of tax incentives to encourage the holding and trading of bonds. And you can see the effect in spreads: bid-offer spreads have come down from between five and 10 basis points to two to three basis points in up to S$10-20 million in size.

TM, CIMB  In Malaysia, we have an active interest-rate swap market, but it's not a market that is entirely efficient: if you hedge using swaps, the bond market may not move in tandem, and the sovereign bond moves slightly out of line with swaps. And in Malaysia you can't short sovereign bonds. Until these two problems are resolved, liquidity will remain at current levels. Investors need to be able short the benchmark bonds to enable themselves to hedge their interest rate exposure. In a sell-down situation, you may like the credit but not the interest rate movement and you need to be able to manage the risks separately. I think if you have that, then market players will be more willing to make two-way prices.

CL, Euromoney  What is investor appetite for Asian high-yield issues such as the heavily over-subscribed Chinese issues we saw recently?

OLL, GIC  Well, there's high yield and there's high yield. Some high-yield paper in Asia is high yield simply because of geography – an issuer like PLDT for example has its corporate rating very much constrained by the sovereign rating of the Philippines. And then you talk about the emerging China issuers. But these issuers are all very different in terms of the stage of their own corporate existence in the context of a rapidly transitional economy. The recent chase for these Chinese names was a chase for yield by investors and also a chase for a newly emerging China corporate sector as a diversifier. In that context, the Asian high-yield space is still in the early stages. A business model that works today may no longer be relevant for the company when new regulatory forebearances  are introduced and an investor has always to be alert to the macro changes as well.

LHC, DBSAM  There are two reasons for the popularity of the Chinese issues. One is that investors are still buying energy issues. Energy is one of the few sectors in which even in the US the spread is still narrowing. Second, until the curve shifts in March, those issues were very attractive from a carry perspective. Now that the curve is flattening, it will be interesting to see whether issuers will have it so easy.

CL, Euromoney  What about covenants? Chaoda Modern Agriculture tried to come with a poor covenants package and then had to cancel and re-issue. Do you think the market has got ahead of itself?

OLL, GIC  Yes. I think of the last quarter as the era of happy investors. Some momentum players would just see a new deal and put in their orders without even knowing the price, the terms, the size, or even understand much about the issuer.

CL, Euromoney  These are hedge funds exploiting the carry trade, right? To what extent have they played a role in Asian bond deals?

ST, Mandiri Sekuritas  We see a lot of hedge fund interest because, with the cost of financing so low and Indonesia being still below investment grade, the pick up is good. This is evident in the presence of foreign investors in government bonds and the rise in interest among foreign houses to set up shop in Indonesia.

CL, Euromoney  Thomas, what do you think?

TM, CIMB  Well, in Malaysia, the niche foreign funds, are putting money into the very short-term treasury bill market. Where they are going into corporates, it's in the high-grade paper and on very short durations. The real corporate credit market is driven more by the onshore investors currently. There is no high-yield market in Malaysia because at that credit level the banks, given their liquidity, are aggressively bidding for that business. Also, investors are not convinced that people will make consistent two-way prices in high-yield paper and in fact there are regulatory constraints with trading below triple-B. And there are insurance regulations that are a hindrance to the development of the high-yield market.

LHC, DBSAM  Singapore faces a similar problem. And in any case most domestic bonds are unrated and so the concept of high yield is slightly complicated. At one point in time we had significant outstandings in the real estate sector. Then a number of issuers went down, and it was a painful lesson for investors to realize that they had to be careful about analyzing credit quality. But in general, given Singapore's sovereign rating (triple-A), most issues in the market are investment grade.

CL, Euromoney  Picking up on something mentioned earlier, the Asian market is still quite a vanilla market, dominated by investment grade issues. But what about growth in other product types?

LHC, DBSAM  One successful product has been REITs, which investors view as a hybrid between bonds and equity because they provide an income stream.

CL, Euromoney  And REITs themselves are now starting to issue debt secured on their assets. Are they attractive?

LHC, DBSAM  That depends on the strength of the underlying company. We'd analyze that just as we'd analyze any other credit.

Islamic products gain acceptance

CL, Euromoney  Lay Leng, what's your view on new products?

Thomas Meow, CIMB: Islamic
products are becoming more
standardized and more
accepted in the non-Islamic

OLL, GIC  The one interesting new asset class for me is Islamic products. Basically, there is nothing mysterious about them, if you do your homework on the credit of the issuer and understand the covenants related to the structure. Unlike conventional asset-backed securities, these Islamic bond structures  are essentially asset-based transactions to allow payments to be made to holders of these securities as interest on money is prohibited. CL, Euromoney  Yes, Islamic products seem to have entered the mainstream. Is that true across Asia?

TM, CIMB  Yes, I think what is happening is a convergence of what people believe to be compliance with the Islamic principles – and so you have standardization. Also these products have become more accepted in the non-Islamic marketplace and investors now view them as simply another product to be compared with other similar credits. And that means issuers can now do large, keenly priced deals that were not possible before. In Malaysia, if you do an Islamic bond, you attract more investors than if you do a conventional bond issue.

TM, CIMB  But globally it is still the reverse. Islamic issues attract fewer investors, which may make pricing to the issuer slightly more expensive.

OLL, GIC  The key to investing in these securities is that because of the embedded structure. You must be very sure of the credibility of the issuer to be able to perform the payment to you as holder of the note. But that is not so different from investing in conventional structured paper. And these instruments give us diversification, which is why I think they are both interesting and defensive.

CL, Euromoney  What about liquidity?

OLL, GIC  It follows the soundness of the credit of the issuer and is generally positive for major sovereign names. At the moment, there is more money chasing limited Islamic products.

TM, CIMB  When you trade bonds in Malaysia, people don't differentiate between Islamic bonds or conventional bonds any more.

OLL, GIC  On the dollar side, however, the acceptance is not there. For example, you cannot deliver the Malaysia sukuk bond into the Malaysia credit default swap contract, so in that sense it's not really on a par with a conventional Malaysia international bond – which is unfortunate, because it's basically the same credit you are talking about. Also, to gain a broader audience, there should be a harmonized standard for international acceptance of what is Sharia-compliant and better promotion for conventional investors to know about these securities.

CL, Euromoney  Stephanus, what is the status of these products in Indonesia right now?

ST, Mandiri Sekuritas  At a very early stage. Issuers would like to tap the Islamic bond market, but no real money has flowed into this market. This is evident from the illiquidity of the secondary market in these instruments. But with interest rates changing direction, there might be more interest in the future. The government itself has to amend its bond law to enable issuance. Once this takes place and a benchmark is set, more issuance can take place.

CL, Euromoney  Let's move on to one final topic and talk about the Asian bond fund. ABF2 is on its way and will be US$2 billion. What are the implications?

LHC, DBSAM  This initiative was a result of the Asian crisis. At that time, there was no way investors could move out of the equity markets without leaving the domestic market completely. That created sharp currency drops and so the crisis. So the first initiative, in June 2003, was the US$1 billion Asia Bond Fund 1, whose purpose was to invest in sovereign and quasi-sovereign bonds issued by Asian governments in the international markets. With ABF2, the intention is to invest in the local currency bond markets of around eight countries.

CL, Euromoney  It's not a lot of money to go around eight countries? Local liquidity is far in excess of $2 billion.

LHC, DBSAM  The purpose is not so much to enhance the flows into the markets, it is more to overcome the remaining impediments to the development of traded, liquid local currency bond markets. These impediments include foreign exchange issues, settlement problems, tax issues and so on. By investing through ABF2 they will understand first-hand the problems investors face.

TM, CIMB  I think it will be useful because, at the end of that exercise, you will have a pan-Asian basket of bonds that will act as a sort of benchmark for global investors.

OOL, GIC  It's not the absolute amount that's important. The fact that this is an initiative on a coordinated basis is symbolic. The reason why developing markets in the early stages usually go through fits and starts is because of the lack of a diversified pool of players. This fund will help create smoother development for the whole Asian fixed-income environment. 

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