Finding alpha in Asian bonds

Asian fixed income is probably still the appropriate asset class for investors seeking capital preservation, high credit quality and strong underlying fundamentals, according to Cecilia Chan, chief investment officer for fixed income in Asia-Pacific at HSBC Global Asset Management.

Asian fixed income exceeded expectations in 2012. In January last year, the market was concerned that yields for Asian bonds were already low. But the reality was that yields declined further. “The whole yield curve shifted down,” says Chan.

However, she is bullish on finding opportunities in an environment in which it will become more difficult to make money in Asian bonds. Last year the euro crisis and other macro risks drove investors to the safety of low-risk asset classes, but the world today is more stable.

“I don’t expect interest rates to fall more, and I don’t expect local government bonds to generate alpha in the form of capital appreciation, except for a few markets such as India,” Chan says. “But changes in yields will be uneven. I expect yields will rise in the long end of the curve first, so we would have some trading opportunities along the yield curve.”

Currency appreciation is another way to generate returns from fixed income as the Asian currency story is still bullish.

Chan explains that the short end of the yield curve is more affected by local monetary policy and changes to interest rates. The long end of the yield curve historically correlates more to US Treasuries, especially in markets such as the Hong Kong dollar bond.

“We expect US Treasury yields to grind higher. So we will go for shorter duration but long Asian currency risk,” she says.

Chan manages the firm’s Hong Kong dollar bond portfolios as part of its Asian fixed-income strategy. Despite the shrinking yield, she believes this asset class is still appealing to local government institutions, insurance companies and Mandatory

Provident Fund (MPF) fund managers, whose liabilities are denominated in HKD and who typically look for relatively higher stability, lower risk and better quality of assets.

Access to HKD bond market
For many, the simplest way to access Hong Kong dollar bonds is via an exchange-traded fund. Although Chan is an active portfolio manager, she also manages a HKD bond ETF, as she sees the benefits of going passive for certain exposures, such as HKD.

“An ETF investing in HKD bonds offers better potential yields than cash,” she explains. “It is well diversified along the yield curves and the fees are lower than what you would pay for an actively managed investment vehicle. Finally, it trades on the Hong Kong Stock Exchange, so it is transparent and easy to access.”

In addition, an ETF makes sense because most HKD bond investors tend to employ the ‘hold-to-maturity’ strategy, so there are comparatively fewer chances for active managers to add value, unlike in other Asian bond markets.

“If you are the type of investor who recognises the diversification benefit of Hong Kong bonds, as well as being cautious about the transaction costs involved, then accessing the market via ETF might be ideal,” Chan says.

Credit matters
On the credit front, Chan is satisfied that there should not be major deterioration in credit quality. The improved global macro story will be good for corporate fundamentals, and she does not expect an increase in defaults.

The question for credit is valuations: spreads are already tight, and the market is digesting a lot of new issuance, often at current expensive levels.

“As the year progresses, we will have chances to cherry-pick the best credits, and outperform more by security selection,” Chan says.

“Markets are normalising but there will continue to be plenty of volatility. We can return to relative value trades. I expect to see far greater dispersion of results among fund managers, which means security selection returns to the centre.”

For Asian bond managers, the idea of a ‘great rotation’ by investors out of bonds and back to risk assets does not mean that the bond story is over. Chan agrees this rotation will take place but it will be gradual; there are still enough macro concerns out there to keep exuberance in check.

More important is the acceptance by many investors of Asian fixed income as a core allocation. Before the 2008 crisis, Asian bonds would have readily equated to ‘risk’.

Today they are a strategic exposure.

“Before the 2008 crisis, local investors, including private banking clients, preferred to hold equities and cash, but they’ve come to understand that Asian bonds provide lower volatility than stocks and a much better return potential than cash,” Chan says.

And bonds are the best way to participate in the ongoing currency-appreciation story, which applies to most of the regional markets.

The deepening of the market, together with favourable demand/supply dynamics, are seen as providing a strong backdrop for the Asian fixed income markets in the year ahead.

Chan expects the positive drivers in 2012 as likely to hold in 2013 and the propitious technical factors to stay in place. Global investors are expected to continue raising their strategic portfolio allocation to Asia given the region’s relative macro strength and the higher yields that Asian bonds offer.

“Besides,” she says, “US short-term interest rates are still going to be zero through 2014. The great rotation will be a long-term trend.”

Investment involves risk and past performance is not indicative of future performance. Issued by HSBC Global Asset Management (Hong Kong) Limited.