Is there an Asian local bond bubble?

The Asian Development Bank (ADB) dismisses the notion that an Asian local-currency bond bubble is forming, as increasing flows to the asset class continue to push down yields. Yet Raymond Chan, Allianz Global Investors' Asia-Pacific CIO, takes the opposite view.

The region continues to attract net inflows into the asset class, with the outstanding LC bond market expanding to $6.2 trillion, or 3.5%, in the third quarter, according to the Manila-based bank’s latest Asia bond monitor report. (It should be noted that ADB is an investor in and issuer of bonds and wants to encourage the development of Asian LC bond markets.)

This increased inflow coincides with a general downward shift in emerging East Asian bond yields. South Korea’s 10-year government bond market, for example, saw its yields fall by 66 basis points between the end of July and the end of August.

But Asia is not facing a bubble in its LC bond market, says Iwan Azis, head of ADB’s office of regional integration. “If you look at the composition of the bond market in Asia, you know it’s still dominated by government bonds. And government bonds are usually longer-term, safe and usually in local currency.”

Government bonds currently account for 66% of the Asian LC bond market, or $4.1 trillion of bonds outstanding. They are also said to be safe, with such debt backed by the huge currency reserves held by regional central banks in Asia. According to the latest AsianInvestor figures (in the July edition), the top 10 Asian central banks have an accumulated balance sheet of nearly $6.7 trillion.

With more liquidity in the Asian debt market, Azis is optimistic for the future, pointing to the low risk of a bond market bubble in the region. "And I am sure in the coming years as well that the bond market will become the major source of financing for the development of most Asian countries – especially in most East Asian countries.”

In contrast, Chan at Allianz GI says there is “certainly a bubble in the making” in the LC bond market. He points to Indonesia in particular, where nearly 30% of its LC government debt is held by foreign investors, according to ADB.

“Inflation has come down, interest rates have come down [from 6% to 5.75% in February from as high as 12.75% in early 2006], and of course foreigners want to buy local bonds,” Chan says. “As a result of that, the currency appreciated. As foreign investors, we love the currency to appreciate. We love the bond price to move up.”

The Indonesia rupiah appreciated by around 6% between the end of January and August (from 9,073 to 8,534 to the US dollar) but year-to-date this trend has largely reversed, with the currency weakening by 5.6% to 9,126/USD.

Indonesia’s one-year government bonds saw yields jump 43 basis points to around 5% between end-June and end-September, but fall again by end-October on positive sentiment from Standard and Poor’s, the rating agency, which signalled it may upgrade the country’s ratings.

“[But] the signs [of a bubble] are there; we have seen that foreigners holding their bonds in terms of their duration [have] actually moved down from 9 months to around three months,” warns Chan.

The worry stems from the Indonesian government, which is under pressure to rein in its current deficit. The deficit is expected to grow to 2.3% of GDP, from 2.2% in the third quarter. Part of this includes government plans to remove fuel subsidies, potentially pressuring inflation and currency to appreciate. Inflation has already inched up to 4.61% in October from 4.3% in the previous month.

“If [inflation continues and] the cycle is turned, foreigners will be the first to sell their bonds,” says Chan.

The LC market accounts for more than 90% of the total Asian bond market, with the remaining foreign-denominated currency bonds accounting for $647 billion by end-June, by ADB data.