Morgan Stanley sees bright future for Asian local-currency bonds

Anniversaries seem to be coming thick and fast for State Street Global Advisors. Having celebrated 10 years of the Hong Kong Tracker fund in November, the US asset manager this week clocked five years since the launch of the ABF Pan-Asia Bond Index Fund (PAIF) it manages. The birthday was marked at an event hosted by Jay Hooley, Boston-based group chief executive.

The exchange-traded fund -- which tracks the iBoxx ABF Pan-Asia Index and measures the performance of government and quasi-government bonds in eight Asian markets -- has posted some strong figures since its inception.

Developed and seeded with $1 billion by a group of 11 Asian central banks and monetary authorities to boost liquidity in local-currency bond markets, PAIF has since doubled in size to $2 billion and delivered an annualised return of 6.96% as of June 30. Those flows have come from retail, high-net-worth and institutional investors.

Around 4% of the fund's 7% return is due to coupon income, and the remaining 3% from currency appreciation, says Bernard Reilly, Sydney-based head of Asia-Pacific at SSgA.

Of course, past performance is no indicator of future performance. Moreover, interest-rate rises are on the cards and indeed are already occurring in some Asia-Pacific markets (so far, in Australia, India, Korea, Malaysia, Taiwan and Thailand).

So, notwithstanding the currency-appreciation element, could it be that now is not the best time to invest in local-currency bonds for the debt component, due to the likelihood of continuing hikes in interest rates?

"The yield has been relatively stable over the life of the PAIF," says Reilly. "There are two parts to the currency equation: the strengthening of local currencies versus the weakening of the US dollar -- so it depends which side you want to take.

"Without giving a specific view on currencies -- because I'm not really able to do that -- [PAIF] has been a good investment for the past five years and should continue to be a good investment for the foreseeable future, given the state of the Asian economies compared to the rest of the world," says Reilly.

SSgA also makes the point that the region's central banks will adopt a very careful pace of normalisation of interest rates, ensuring that they strike the delicate balance between not choking off the fragile recovery and maintaining price stability. 

Other market participants take a similar view. With regard to the likely return from Asian local-currency bonds, "a lot of it is FX-dependent, because of currency appreciation being one of the main drivers of returns, given that bond yields are quite low", says Pieter Van der Schaft, a local-currency fixed-income specialist at Morgan Stanley in Hong Kong.

"But if you have continued demand for Asian currencies, that leads to a lot of inflows into these markets and a lot of expansion of liquidity in the banking system, which will usually be redeployed back into bonds," he tells AsianInvestor.

A third point Van der Schaft makes in support of the positive outlook for local-currency bonds is that there is structural demand for yield, and for emerging-market assets as alternatives to US Treasuries, German bunds and the like.

Hence he sees strong inflows into local-currency bond funds continuing and says institutional investors are also becoming more interested in emerging-market local-currency bonds. "That may lead to more inflows into cash bonds across the curve," he adds, "not only five-year [maturities], but also longer tenors."

As for the likelihood of Asian currencies appreciating, some of them are fully valued and some are undervalued, says Van der Schaft. He cites the Korean won as the clearest example of an undervalued currency in Asia, with the Hong Kong dollar also somewhat undervalued on a real trade-weighted basis.

In addition, the Singapore authorities have adopted a tighter monetary policy stance on the Singapore dollar, which means they are targeting appreciation against the trade-weighted index, he says.

Meanwhile, FX strategists agree that the Indonesian rupiah is fully valued.

As a result, says Van der Schaft, there should be structural demand for Asian currencies, for emerging-market assets in the medium term, given how low the Fed funds rate is and the prospects for growth in such markets. Even where some are fully valued, they could become overvalued in real trade-weighted terms, he adds, and some of the laggards could catch up.

But if currencies will be one of the main drivers of returns in Asia, why not get direct FX exposure by buying the currencies directly rather than the bonds? "Because bonds provide higher yields and rolldown returns than FX non-deliverable forwards, which often trade at a discount to onshore money-market rates in times of FX strength," says Van der Schaft.

So the future for the PAIF seems fairly bright. A further attraction of the fund, says Reilly, is that it is the only foreign investment vehicle that is permitted to invest directly in the Chinese inter-bank and exchange-listed bond markets. Hence it's enabled investors to participate in the country's growth story other than through the Chinese equity market, he adds.

Moreover, the geographical spread of PAIF investors is widening. "We saw a lot of success initially in Asia, and we're now seeing investors from mainland China and we also have investors from Europe," says Reilly, who expects to see a broader range of investors coming in, in particular from Europe and North America.

"We spend quite a bit of time in Europe talking to our institutional clients about this fund, says Reilly, adding that there hasn't been so much interest from the US as yet. He says this is probably because US investors have tended to invest more at home than abroad, while Asians and Europeans are more inclined to look beyond their borders.

Moreover, five years ago the PAIF was paying a yield substantially lower than that of US Treasuries, and yet Asia was deemed to be higher risk, says Reilly. "But clearly now US Treasuries are yielding substantially lower than this fund, and arguably risk in developed markets might have been under-priced, given what we've just experienced [during the crisis]," he adds.

Investors' interest in local-currency bonds appears to be backed by commitment from Asian regulators, if the Monetary Authority of Singapore (MAS) is anything to go by. Ong Chong Tee, deputy managing director at the MAS, in a speech earlier this month to the NUS Risk Management Institute, commented on the importance of developing local-currency bond markets, but noted that there are challenges in doing so.

Given that these markets remain largely domestic, he said, Asian countries will not only need to develop them, but also look at improving cross-market access, including harmonising of standards and documentations.