Asia Bond Watch: Hard or local currency bonds?
Asian local currency government bonds, as measured by the Markit iBoxx ABF Pan-Asia Unhedged Total Return Index, delivered 10% returns in 2017 but lost ground in the six-month period to the end of June this year at -2%1. Similarly, Asian hard currency government bonds, as measured by the J.P. Morgan JACI Sovereigns Total Return Index, returned 9% last year but have underperformed local currency markets in the first half of 2018, recording a negative return of -5%2.
In 2017, falling US inflation and better-than-expected performance in Europe saw a surge of new flows into European investments, pushing the euro higher versus the dollar. The dollar, however, remained range-bound, despite US Federal Reserve rate tightening. Muted inflation and accommodative monetary conditions in Asia created attractive investment conditions for yield-hungry investors.
That said, fortunes reversed in 2018 as US economic strength, expectations of a faster rate-hike schedule, rising oil prices and an impending trade war combined to prompt a resurgence in the dollar. Quantitative tightening also has the effect of reducing dollar liquidity. Meanwhile, the European economy had slowed on weaker data and rising political risks, notably in Italy. Debt woes in Argentina and Turkey further undermined investor confidence, further driving investors into safe haven assets such as the dollar.
HIGHER RATE AND STRONGER DOLLAR EXPECTATIONS DETER INVESTORS
A strengthening US dollar has long been the nemesis for emerging market (EM) debt. From the taper tantrum in 2013 (when the US Treasury yields surged as a result of the Federal Reserve’s tapering), to President Donald Trump’s election in 2016, the spectre of higher rates and a stronger dollar have deterred investors. With interest rates so low for so long, emerging nations relied on US dollar financing to shore up their economies.
However, with ongoing reforms undertaken by the authorities, Asian economies have taken huge strides towards rebalancing their current account and fiscal positions. Today, the bloc is significantly less vulnerable to macroeconomic shocks as the dollar strengthens and interest rates rise.
In broad terms, the primary driver of hard currency bond returns is EM sovereign credit spreads. For non-Asian investors, or those who prefer to base their investments in US dollars, these investments pose no foreign exchange risk.
On the other hand, a key driver of local currency bond returns is foreign exchange (FX). Yields on these bonds will, therefore, reflect FX volatility and currency risk premia, making them ideal for investors who wish to diversify away from US dollars. More importantly, exposure to an economy’s currency, as well as its sovereign credits, offers investors more direct exposure to a country’s growth prospects.
HARD VERSUS LOCAL CURRENCY BONDS
One of the most frequently asked questions by investors is – “How should I choose between hard and local currency Asian bonds?”
When deciding between differently denominated bonds, investors will need to consider their base currency and existing portfolio composition, in addition to available yields. For example, the euro has a lower correlation to EM currencies versus the US dollar, so euro-based investors might benefit more from local currency investments. Returns in the hard currency segment tend to follow changes in the US Treasury curve. On the credit side, hard currency has a marginally higher correlation to high yield debt than local currency bonds.
Broadly speaking, for investors who are looking mainly to avoid any currency risk and who want to focus on the Asian fundamentals, they may choose to look into the hard currency space. Investors who are trying to harness the long-term growth of Asian economies may look for opportunities investing in local currencies, in order to enjoy the full benefits of potential bond market returns, plus Asian FX returns.
MORE ATTRACTIVE VALUATIONS
Despite short-term macro risks such as dollar strength and the potential for further trade turmoil, we prefer local currency over hard currency EM debt. With Asian currencies about 5-6 % undervalued against the dollar, according to State Street’s measures of fair value, this represents an opportunity in local currency debt.
Year-to-date underperformance of Asian currencies ran counter to all expectations at the beginning of 2018, but US protectionism, rising rates and weaker growth in Europe shows little sign of abating. These conditions will support US dollar strength, and investors need to exercise more caution as these headwinds continue to weigh on local currencies.
However, after the recent decline, current valuations of Asian bonds may present attractive entry points for discerning investors. Hard currency valuations have come down from their year-end highs, while local currency issuance typically offers better risk-adjusted returns over hard currency debt.
With many Asian countries increasingly issuing local currency debt to a more affluent domestic population, local currency bonds are becoming less exposed to the vagaries of international investment flows. The Asian local currency government bond market has grown significantly from $304 million in total issues outstanding in 1998, to more than $12 trillion at the end of 20173; it presents a rising asset class and widened opportunity set for global investors.
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1. Source: Bloomberg. iBoxx ABF Pan-Asia Unhedged Total Return Index covers China, Hong Kong, Indonesia, South Korea, Malaysia, the Philippines, Singapore and Thailand.
2. Source: Bloomberg. J.P. Morgan JACI Sovereigns Total Return Index covers China, Hong Kong, India, Indonesia, South Korea, Malaysia, Maldives, Mongolia, Pakistan, the Philippines, Sri Lanka and Vietnam.
3. Source: Bloomberg, Asian Development Bank, data as of December 2017.
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