Western Asset sees value in Asian bonds

Rajeev de Mello is the head of Singapore operations for Western Asset and portfolio manager of the Legg Mason Western Asset Asian Opportunities Fund. He joined Western Asset in 2007 after eight years at Pictet, where he was head of Asia fixed income. Prior to Pictet, he spent five years at UBS as head of Asia bond trading and before that he was at McKinsey & Co for two years.

2010 was a strong year for Asian bonds and currencies. Can you comment on currency developments over the year and in recent months?
Rajeev de Mello [RM], Western Asset: Asian currencies were powered by stronger fundamentals as growth rebounded. The first half of 2010 saw a strong, V-shaped recovery continue throughout Asia, and the second half confounded the sceptics as strong growth continued. Overall, we saw good performances by Asian currencies throughout the final quarter of 2010 and a fairly strong start to 2011.

Currencies were strong across the region. The Taiwanese dollar appreciated 6.6% over the quarter. There was a range of currencies in the 1-2% range, including the Chinese yuan, which started appreciating faster after the policy change in mid-2010. Chinese currency appreciation is in the region of 4-4.5% per annum, with 1.5% appreciation in the fourth quarter, broadly what we expect to continue.

It is difficult for Asian countries to let their currencies appreciate much faster than the yuan, because in many cases they export to China. Elsewhere, they compete with China and don’t want to lose competitiveness. Over the year, for instance, the Malaysian ringgit was up 12% and the Thai baht 11%, outpacing the 3.3% appreciation by the yuan. Nevertheless, there will always be concern if the yuan does not appreciate, but we think this should continue this year.

What is the current portfolio allocation to corporate bonds?
RM: Corporate bond exposure in the portfolio can be broken down into investment grade, at about 16%, and high-yield bonds at 4%. We reduced our corporate exposure in October, when we thought we were approaching a period that could be more uncertain. Since the beginning of January, we have slowly started building them back up. Previously, I would say the exposure was as high as 20% for investment grade and about 4% for high yields. We’ve taken it down and are now taking it up again.

What are the implications of inflation developments for currencies and bonds?
RM: Looking ahead, inflation, especially food inflation, is the major risk facing a benign scenario for currencies and bonds. For Asian bond markets, this means that front-end bonds are not that attractive, because they bear the brunt of monetary tightening. But it doesn’t mean that longer maturity bonds are not attractive. They depend on investors’ perception that central banks are credible and also on demand and supply for longer term government bonds. As growth has recovered, government finances have bounced back substantially. Deficits have gone, with some Asian countries in surplus. These countries don’t need to issue many bonds and this helps the longer end of the bond market, especially.

In an environment of slightly higher inflation, we believe Asian currencies will do better and offset part of the loss incurred now by the front end of the bond market. Looking at what is priced in now in the front end of the bond market, it is beginning to get attractive again and we will start buying bonds in Malaysia, the Philippines and Korea.

2010 was a year of capital inflows across emerging markets. Do you worry about potential outflows?
RM: Continuous interest by global investors has been positive for Asian bonds. They see positive fundamentals, falling deficits, reduced total debt-to-GDP and better, more balanced growth in Asia – an appealing shift from export dependence towards greater domestic demand. The financial sector is in good shape, monetary transmission is growing and concerns that banks may be lending too much is among the reasons central banks are tightening. The asset markets are doing well, so are property and equities, and this is attracting further inflows.

But I would put last year’s significant inflows into the context of why people have diversified into Asia. Generally, Asia was significantly under-owned in the West and I would expect most investors to have a small allocation to Asia. When you think about that, are they really likely to take their allocation back down to zero? Assuming there were outflows, some of the biggest investors in each of those markets are Asian investors. Asia is sitting on huge reserves – about US$4.5 trillion, with China holding the largest share. Typically, their investments are in US dollars and US Treasuries and, to a lesser extent, in euros and European bonds, but they are diversifying by investing in each other’s bond markets. Their holdings are still small, compared with their dollar holdings, so diversification will continue and should offset any eventual outflows by global investors.

With much spare residential and industrial property in China, are you concerned about a potential downturn in the housing market?
RM: After a housing bust in the US and elsewhere, can one draw parallels with China and say they are overbuilding? One must put it into perspective, because housing in China has been inadequate and there is a lot of catching up to do. The so-called ‘bubble’ in housing has been at the very top end of the market. This is where authorities have been clamping down. They don’t want an implosion or collapse in the market and are concerned about the high and higher-medium end. However, at the lower end there is a huge shortage and while construction will slow at the high end, it will shift to the lower end.

Don’t forget with growth of about 10% last year, if it's between 8% and 10% this year that still means tremendous construction growth – including industrial construction. Moreover, it’s not a situation where you have a slow-growing country, powered by construction. Rather, construction is keeping up or catching up with overall growth. Fundamentally, there can easily be further growth in residential construction from the lower and the lower-middle ends.

Triggers for a collapse are not present, because it’s not a leveraged market. Loan values are low. Chinese banks, even though they engaged in a lending binge, are cautious. People can't walk away from their homes and, as first-time purchasers, are not likely to. Additionally, the level of loans to value has been low. Households put a lot of capital down when they buy, they don’t leverage. It's far too negative to suggest we could trigger a broader economic collapse with a collapse in the housing market. While the high end of the market might not do well, that isn’t true of the lower end.

How do you see the outlook for the asset class?
RM: We think the asset class will do well over the next three-to-six months. Although we have seen increases in yields in Indonesia and the Philippines recently, we have taken them as a normalisation of bond yields which had done extremely well until the end of October and, at these levels, have bought back some positions. We have increased our duration in Philippines and Indonesian bonds – among the highest yielding in the region. We’ve been buying back those we continue to like, including Singapore dollar bonds. Just as in some other parts of the bond markets in the region, they have a correlation with US Treasury markets, but we have a more benign view on US bonds now with yields having moved back up to the 3.30-3.50% area in the 10-year part of the curve. Generally, we think US growth will recover slowly and, therefore, the Federal Reserve won't risk early tightening. With low Fed Fund rates, low Libor rates, the carry on bonds is very significant and we think that will keep yields in a range.