Why Asia bonds look a good bet during the trade war

As the Sino-US trade war intensifies and exacerbates uncertainty, Asian bonds, including Chinese paper, are generally becoming more attractive to international investors.

“My bias would be to buy China offshore debt on the expectation that a favorable trade deal outcome should cause spreads to tighten,” said Peter Sengelmann, chief investment officer of US investment management and financial planning firm Thun Financial.

International investor demand for Chinese offshore bonds is likely to continue, since many investors want to hedge against the impact of the trade war on the US economy.

“Overall, we prefer bonds to stocks. Equities are much more sensitive and higher risk than bonds,” said Rajeev de Mello, chief investment officer of Bank of Singapore, at a press conference in Hong Kong towards the end of May.

“For emerging markets in Asia in general, we prefer bonds to equities,” said Ben Luk, senior multi-asset strategist at State Street Global Markets, at a press conference in Hong Kong in mid May.

Equities are not recommended because the earnings of many listed Asian companies have not turned around yet, whereas for bonds, investors need only worry about capital flow, inflation and US Federal Reserve policy, Luk explained.

Further weakness in inflation could prompt the US Federal Reserve to cut interest rates, even if economic growth maintains its momentum, James Bullard, President of the Federal Reserve Bank of St Louis, said at the Foreign Correspondents’ Club in Hong Kong recently. Bullard, a voting member of the rate-setting Federal Open Market Committee, said that the Fed was done raising interest rates for now, barring unexpected changes.

The uncertainty and intensity of the Sino-US trade war has increased. As recently as April, the markets were expecting China and the US to reach a trade agreement within a few months.

But at the start of the month, US President Donald Trump tweeted threats to hike tariffs on $200 billion of Chinese goods imported into the US, which were then implemented soon afterwards. On May 13, China retaliated by announcing it would increase tariffs on $60 billion of US goods from June. And a few days after that, the US Commerce Department said that it would ban Huawei Technologies, a Chinese telecom technology giant, from buying components from US companies without US government approval.

ASIA’S HIGH YIELD ALLURE

Compared to the rest of the world, Asia excluding Japan has taken the biggest hit in the past month in equity corrections.

Since the start of the month, the Hang Seng Index has fallen 9%, the Straits Times Index has dropped 6.7%, and the Kospi Index has decreased 6.7%. The Shanghai Composite Index has declined a more moderate 5.5%.

“There is more opportunity to go for high-yield bonds in Asia at the moment,” said State Street Global Markets' Luk.

Higher yields compared to fixed income assets of other regions is the chief reason that international investors have increased their allocation of Asian fixed income products, according to a recent survey by US management consultancy Greenwich Associates for State Street Global Advisors. It talked to 187 institutional investors, private banks and financial intermediaries in Asia Pacific between October and March this year.

“Around three-quarters of surveyed investors said yield is the key reason for increasing exposure to Asian fixed income next year,” said Ng Kheng Siang, Asia Pacific head of fixed income at State Street Global Advisors. “Opportunities to pick up yield from investments in Asian bonds have become even more attractive since the US Federal Reserve’s decision to put off additional interest rate hikes this year.”

With a few exceptions, Asian excluding Japanese bonds offer higher yields than their US counterparts, while the yield curves are negative in Europe and Japan. US 5-year Treasuries are yielding 2.08% versus 3.16% for equivalent Chinese paper and 7.54% for Indonesian govvies, for example. 

In Thailand and South Korea, bond yields are under downward pressure because interest rate cuts are expected in these countries. In contrast, Indonesian and Malaysian bond yields could rise due to investor risk aversion, given the rising trade tension and these nations’ weakening currencies.

“We expect Asian bonds to be mixed, though yields could rise due to weakening currencies and emerging market sentiment,” said Ng.