This is the reproduction of an article in IFR Asia magazine.

In the face of formidable uncertainties this year, investors may still seek the comfort of fixed income, says Dilip Parameswaran.

Despite all the misgivings at the beginning, last year turned out to be a good one for fixed-income investors. Asian dollar bonds ended the year with a return of 5.8%, composed of 4.5% for investment-grade and 11.2% for high-yield bonds, according to JP Morgan Asia Credit Index data. We are beginning another year full of uncertainties. What does 2017 hold in store for fixed-income investors?

The first big uncertainty relates to the path of US interest rates. The Fed has begun raising rates and has signalled that three rate increases are in the offing this year and three more next year. A sustained period of job growth has brought US unemployment down to 4.7%, but more importantly the pace of wage increases to 2.9% per year. While these numbers underpin the Fed’s planned rate increases, the key unknown is the impact on any potential fiscal stimulus on growth and inflation.

That brings us to the second key uncertainty: the Trump administration’s plans for the economy. It is widely understood that the next administration intends to provide fiscal support through a cut in taxes and an increase in infrastructure spending, but the extent of the stimulus and its potential impact are unknown. If these plans start nudging inflation up to a level higher than the Fed’s current expectations, the Fed might have to respond by raising rates faster.

Another unknown is the extent to which the Trump administration’s policies on trade and the dollar will influence key economic variables. Mr Trump has espoused various protectionist views and may tolerate a weaker dollar. While a weaker currency might push inflation higher, the final impact of protectionist trade policies, particularly on growth and employment, is uncertain.

China is the other piece in this moving puzzle. At the beginning of last year, worries about China’s economy dominated the markets, but as time went on, growth began to stabilise and greater uncertainties – including the US presidential election – took over. This year too, the markets are resting on the comfortable assumption that China would manage growth of about 6.5%.

But China still faces a myriad of economic issues, all of them carried over from the last year. While economic growth last year was propped up by continued flow of credit to the economy, the total debt in the system has reached close to 300% of GDP, according to various estimates. China also faces the challenge of rising capital outflows in response to slowing growth and a depreciating currency. While property construction was a key support for the economy last year, property prices in many cities have risen to such unsustainable levels as to prompt a round of regulatory constraints. The government may provide a measure of support to the economy through an expanded fiscal deficit, but it would exacerbate the challenge of managing the total debt in the economy. On top of all these domestic economic issues, there is the added challenge of a strained trade and political relationship with the US. China may yet emerge as one of the key trouble spots this year.

Where does all this leave the fixed-income investor in Asia? We believe that Asian dollar bonds could again produce positive returns of 2%-3%, without leverage.

One key driver of the returns is, of course, US Treasury yields. Based on the current expectations for the Fed rates, we believe the 10-year yields could rise by about 50bp over the year to reach close to 3%.

The spreads on Asian dollar bonds narrowed by about 25bp last year for investment-grade and 130bp for high-yield bonds, according to the JACI data. This year, we expect investment-grade spreads to finish flat and high-yields bonds to widen by 50-75bp. This is primarily because the positive performance last year has left Asian spreads somewhat tight by historical standards and in comparison with US spreads.

Credit defaults are unlikely to turn into a big issue for Asian bonds. Moody’s expects that, after a temporary pick-up in the early part of the year, the global high-yield default rate will edge down from 4.4% to 3% over the year. In Asia, defaults have always been episodic and not systematic. Given the prevalence of family ownership, government connections and bank support, Asian issuers have averted defaults in many difficult situations.

The technical factors for Asian bonds were strong last year. Nearly three-quarters of Asian bond issues were placed within Asia, up from 63% the year before. Support from Chinese investors in particular has been one of the contributing factors. We expect these factors to continue supporting the market this year as well.
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While some market players expect a wholesale shift of funds to equities this year, the so-called “great rotation” has so far proved to be the wolf that never came. With major uncertainties confronting the economic world this year, investors might yet prefer the cosy comfort of fixed income for a while yet.

This is the reproduction of an article published in the IFR Asia magazine.

Asian bonds are yet again likely to generate positive returns this year and provide a measure of stability to investors’ portolios, says Dilip Parameswaran

The year has not exactly started well for many asset classes. Oil has sunk to prices not seen in the last 12 years. With another sudden downward lurch in its currency, China has injected more concerns into the market about its economy, dragging other commodities further down. Equity markets have taken fright, with the Dow already down 9% since the start of 2016.

Against this background, there is one question on the mind of every investor: “With the Fed poised to raise again this year, what does the future hold for fixed-income investments?” In our assessment, the answer is not as negative as you might think: US dollar bonds from Asia can generate a total return of 2%–4%, without leverage.

Last year, Asian bonds generated a total return of 2.8%, split into 2.2% for investment-grade and 5.2% for high-yield bonds, according to JACI index data. This year’s returns are likely to be on a par with those.

When considering the outlook for this year, the first point to appreciate is that Asia is still an attractive growth story. China’s economic slowdown being partly compensated by India’s pickup, Asia ex-Japan is still set to grow at 5.8% this year and next, according to the IMF’s forecasts. This stands in stark contrast to the outlook for other emerging markets, which are suffering from a mix of problems, including low commodity prices.

THIS YEAR’S EXPECTED total return from bonds depends on many moving parts. The first is, of course, the likely increase in the Fed funds rate and the medium-term Treasury yields. Economists hold different views on how much the Fed would raise the target rate. Some point to the persistently low inflation, others talk about falling unemployment, and some highlight the potential for global issues (including China) to slow the pace of rate increase. But overall, the Fed funds futures are currently pricing in a Fed funds rate of 0.6% for the year-end. That indicates the potential for medium-term Treasury yields to rise less than expected, perhaps by 50bp.

The second key element is the credit spreads. According to the JACI data, the average Asian bond at the end of 2015 traded at 293bp over swaps, broken down into 222bp for investment-grade and 596bp for non-investment-grade. These spreads are eight times the pre-crisis levels for investment-grade and over six times for non-investment-grade. Although one may argue that the pre-crisis levels reflected unjustified and unsustainable exuberance, the current levels are still higher than the post-2009 average spreads by about 25bp for investment-grade and 140bp for non-investment-grade.

Compared to the US credit markets too, Asian bond yields are still higher, by about 90bp for investment-grade and 50bp for high-yield.

In our view, the current spreads reflect neither a significant overvaluation, nor undervaluation. Consequently, they indicate the potential for the spreads at the year-end to stay close to their current levels, perhaps within 20bp.

The third determinant of returns is defaults. At a global level, high-yield default rates are likely to pick up: Moody’s expects the global high-yield default rate to reach 3.7% by November 2016, a level that is higher than the 3% for last year, but still lower than the longer-term average of 4.2%. In Asia, most of the defaults have been triggered by the crash in commodity prices and the economic slowdown in China. These factors are likely to keep Asia’s default rates elevated, but should not lead to a spike.

THE TECHNICAL FACTORS for Asian bonds are likely to be supportive this year. Already, many major issuers have turned to Chinese domestic bonds instead of US dollars, as it offers them cheaper funding and reduces their currency risk. This year’s supply of new bonds is also likely to be restrained by the same trends, particularly in the China high-yield sector.

At the same time, the demand for bonds has remained strong, in particular from the institutional investors in the region, who picked up 63% of new issues in 2015, up from 58% in each of the three years prior to that. For most investors, Asian bonds have become a mainstream asset class, rather than a frontier asset class; and they are likely to maintain their presence in Asian bond markets in the medium- to long-term.

Based on these factors, we expect Asian bonds to generate total returns of 2%-4% if five-year Treasury yields rise by 50bp. Even if the five-year rates rise by 75bp, which seems aggressive given the uncertainties surrounding further rate increases, Asian bonds can still generate positive returns in the range of 0.7%-3%.

Given the higher yields and lower duration, high-yield bonds on the whole are likely to generate higher returns than investment-grade bonds by about 200bp in the base case. However, the challenge for investors is likely to be one of avoiding the potential defaulters. That is no easy task, since the defaults are triggered not only by economic, but sometimes by political factors as well. Another challenge of investing in high-yield is the lower liquidity due to the shrinking capacity of banks to hold inventories and make markets.
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In an environment of so many uncertainties – including those around the Chinese economy, commodity prices and geopolitical risks – we believe investors should maintain a reasonable allocation to fixed income to provide stability to their portfolio returns.

This is the reproduction of an article published in IFR Asia magazine.

While the world’s attention was focused on Greece’s negotiations with its lenders, another crazy spectacle was unfolding on the other side of the world. After running up 150% in the 12 months to June 12, the Shanghai stock market plunged by nearly a third in the next month.

There had been no fundamental reasons for the exuberance. China’s economy had in fact been slowing, with GDP growth at 7% in the first two quarters, down from 7.4% for the last year. The property sector, an important contributor to the economy, had also been struggling, with both volumes and prices showing a marked slowdown. Corporate profitability had been squeezed and unofficial estimates of non-performing loans in the Chinese banking system had been rising. The central bank only started cutting rates in November 2014, by which time the rally was already in full swing.

On the contrary, the run-up had been related primarily to a significant flow of financing to the stock market through a variety of channels: margin financing, collateralized lending, shadow financing through trusts, and direct peer-to-peer lending. While the overall value of borrowed funds in the stock market is difficult to judge, some estimates put the value as high as a third of all floating shares.

This diversion of funds could be in part a result of cooling property markets. As the property markets began to cool, the private savings that had been invested in it through shadow-banking channels began to be diverted to lending against stocks, in search of returns in the high teens.

Retail investors got caught up in the frenzy in the late stages of the rally, helping push the markets even higher. According to reports, more than 80 million retail broking accounts were opened towards the end of the rally.

As the market crashed, there was panic all around. Listed firms chose to suspend trading on their shares (nearly 50% of the Shanghai index was suspended at one point), and investors tried to cash out. But regulators panicked too. They organised a coordinated rescue by injecting Rmb120bn, first tightening and then relaxing the rules for margin financing, stopping IPOs, and changing the rules for opening of trading accounts. The central bank also announced another cut in interest rates, and authorities are now looking for foreign funds that might have shorted the market (and have started suspending some trading accounts of foreign fund managers). The stock market then went through several days of further volatility, but the precipitous crash had been arrested.

WHAT IMPACT IS the recent stock volatility likely to leave in its wake – assuming that the worst is indeed over for now? First of all, there is no doubt that faith of the common man in the stock markets has again been shaken, making Chinese investors question the viability of the equity market as a repository for their savings, at least in the medium term.

What China needs in the long run is to develop the equity market as a stable avenue for financing for businesses, particularly private-sector companies and small and medium enterprises. At the end of 2014, China relied on bank credit to finance its private sector to the extent of 142% of GDP, far higher than the ratio of 50% in the US, according to the World Bank. Conversely, China’s stock market capitalization was only 44% of GDP versus 116% in the US in 2012, again on World Bank data.

This reliance on bank credit leads to distortions in the allocation of capital to the most profitable and deserving businesses. Developing domestic stock and bond markets is a key necessity in improving the efficiency of capital. This year’s stock volatility – and another IPO freeze – is a setback in that process.

The government’s actions have also given rise to a version of moral hazard. There is already a persistent belief in the bond markets that the government will rescue troubled companies, leading to mispricing of risk. Last month’s intervention has created a similar belief among equity investors.

Individual investors, who account for a large proportion of equity trading volumes in China, are only likely to have been left with a confused impression of equity as a method of savings.

FOREIGN INVESTORS HAVE also been caught in the maelstrom, with monthly net purchases of mainland stocks under the Shanghai-Hong Kong Stock Connect scheme turning negative in July for the first time since the scheme was launched last November. Investors also found that some of the eligible Chinese stocks had been suspended from trading. In fact, 10 of the SSE 180 index stocks, all of which are eligible for Stock Connect, were still frozen at the time of writing.

In the coming months, we will know if the crash has dented consumer confidence and retail sales, but it is still too early to see the impact on the real economy. For the property sector, on the other hand, the crash may turn out to be a blessing, since savers may turn back to buying property as their preferred saving method. Already, there are mounting signs of stability in the property market, and the stock crash may further help strengthen the sector.

In February this year, US academics published a paper for the National Bureau of Economic Research arguing that “China’s stock market no longer deserves its reputation as a casino”.

The authors measured the ability of market valuations to differentiate between firms that will have high profits in the future from those that will not, concluding that “the informativeness of stock prices about future corporate earnings [in China] has increased steadily, reaching levels that compare favourably with those in the US.”

Had they sought to measure the rationality of the overall market valuation (as opposed to the ability to differentiate between firms), I wonder if they might have reached a rather different conclusion.

The first challenge facing Asian credit is the global economic backdrop. The most important hurdle this year is the impending rise in US interest rates and its impact on asset markets. Although the consensus is for rates to finally start rising in the third quarter, the potential pace of that increase is unclear, particularly in the face of the stubbornly low inflation.

In Europe, growth is stalling even for countries with strong balance sheets, and the economy is inching closer to deflation. Greece’s sudden elections may trigger renegotiations with other eurozone countries and raise the spectre of a currency breakup. Japan remains an experiment in progress, with the success of Abenomics far from assured in the face of faltering growth and sluggish exports.

By contrast, the economic picture in Asia is much brighter. Although various indicators have repeatedly shown that the Chinese economy is slowing, there is enough room for fiscal and monetary relaxation to maintain a growth rate close to 7% for 2015. India’s new government faces a rare confluence of positive factors. Lower oil prices will bring the current account closer to balance and reduce inflation, enabling interest rates to be cut and fuelling a pick-up in growth. The new government in Indonesia has also begun to take difficult decisions to cut fuel subsidies and devote more funds to infrastructure development. Its reform agenda is likely to support a gradual uptick in growth.

Overall, the International Monetary Fund forecasts Asia ex-Japan to maintain its growth steady at 6.3% for 2015, beating the outlook for other emerging regions, including Russia, Eastern Europe and Latin America and attracting investors to raise their allocations to Asia.

ACCORDING TO THE JP Morgan Asia Credit Index, Asian spreads ended 2014 exactly where they started: 262bp. While investment-grade spreads ended up at 188bp, just 8bp tighter, non-investment-grade spreads widened modestly by 58bp to end at 534bp.

At the current levels, Asian spreads are still much wider than before the 2008 global financial crisis: investment-grade spreads are more than double (188bp versus 83bp) and non-investment-grade spreads are more than thrice the pre-crisis levels (534bp versus 167bp).

In comparison to US spreads, Asian investment-grade corporate bonds provide a yield pick-up on average of 120bp, and Asian non-investment-grade corporate bonds pay 190bp more at the same rating and maturity. While some of this may be attributed to poorer liquidity, more complex legal systems and macroeconomic vulnerabilities, it still indicates the premium that Asia can provide.

Although the year has begun with a potential bond default by China’s Kaisa Group, a multitude of defaults through the year is unlikely in view of the reasonable economic growth and sustained liquidity for refinancing. The gradual relaxation of property policies in China should also support the Chinese property sector.

International bond issues from Asia hit a record of US$210bn last year, and there should be no problem in finding buyers for another year of heavy supply. One positive development in the last five years has been the superior ability of Asian investors to absorb Asian bonds, taking 57%–58% of last year’s new issues, up from 40%–45% of a much smaller volume pre-crisis. While the share of retail investors has declined (to 10% last year from 14% in 2013 and 16% in 2012), institutional investors have stepped up to absorb the ever-increasing supply.

That brings us to the question of what will happen when interest rates start rising. Based upon previous rate cycles, there is no evidence to support an automatic widening or narrowing of credit spreads; rather, spreads depend on the prevailing macro and credit environment. For example, in 1993–94, as the Fed raised rates by 300bp, average BBB credit spreads declined by about 30bp; in 2004–06, when the Fed raised rates by 425bp, spreads fell 80bp.

GIVEN THE REASONABLE economic growth, subdued default rate, higher spreads in Asia and the growing investor base, our base case is that Asian spreads would contract by about 20bp this year, delivering a total return of about 3% assuming five-year Treasury yields rise about 70bp. While this is lower than last year’s total return, it must be remembered that about 60% of last year’s return came from falling Treasury yields, a supporting factor unlikely to be repeated this year.

However, our forecast is not meant to rule out high volatility or idiosyncratic risks during the year. If oil and commodity prices continue to decline, or if the Russian situation gets worse, emerging markets in general could suffer and a contagion effect could reach Asia as well. While it stands to reason that Asia would be a net beneficiary of lower oil prices, and investors should be able to differentiate Asia from other emerging markets, volatility may still affect valuations in the interim.

Europe still has the potential to emerge as a significant source of volatility, if either Greece were to depart the currency union, or QE fails to revive growth and lift inflation. Closer to home, China could roil the markets, too, if it struggles to rev up its economy or if Chinese local-government debt becomes a challenge.

The consolation in these cases is that the Fed might be pushed to slow the pace of rate increases, and equity markets may perform worse than expected, again prompting higher allocations to fixed income.

Within Asian credit, although we are tempted to say that high-yield bonds would outperform investment-grade bonds in view of their higher carry, volatility in high-yield is likely to be much higher this year and one or two mistakes could wipe out the returns from a high-yield portfolio. Individual risks have risen in Chinese property, and some lower-rated issuers may find it difficult to refinance their maturing bonds. Issuers from the resources sector from Indonesia and China are at risk of a further slide in commodity prices. Subordinated debt issues from banks are also pressuring higher-rated high-yield bonds. Our preferred strategy is to overweight investment-grade, while maintaining an exposure to high-quality high-yield names.

This is the reproduction of an article in IFR Asia.

To many global investors, bonds from China’s property sector are toxic nuclear waste, not to be touched at any cost. To others, they come with a more pragmatic “handle with care” warning. I belong to the latter camp.

From just a handful of bonds 10 years ago, the sector has grown to contribute 9.5% of the Asian US dollar bond market with US$51bn of bonds trading. That is nearly a third of all high-yield corporate bonds in the region.

Over this period, the sector has gone through three cycles of downturns and upturns. Several Chinese property companies have issued, redeemed and refinanced their offshore bonds. Companies with credit ratings ranging from Single A to Triple C have managed to issue bonds, which trade actively in the secondary market. Yet, a feeling of unease persists.

Perhaps the first source of discomfort is the fact that offshore Chinese property bonds are deeply subordinated, since they are issued by offshore-incorporated entities, which inject the bond proceeds as equity into their onshore companies and service their debt only out of equity dividends received back from the mainland. The difficulties in repatriating equity funds out of China mean that the offshore principal effectively has to be refinanced. In case of bankruptcy, the onshore lenders have the first claim over the onshore assets.

While this structural weakness is undoubtedly true, it applies to every other bond issued by Chinese businesses, including investment-grade bonds far beyond the property sector, since the structure was born out of regulations prohibiting the issuance of debt or guarantees by mainland companies. (Only recently have the authorities begun to relax this prohibition, and the first few offshore bonds are now coming out with direct guarantees from mainland operating companies.)

ANOTHER SOURCE OF discomfort is the government’s meddling in the property sector through various measures, including the flow of credit to the builders, rules for financing land purchases, obtaining mortgages, and mortgage down-payment requirements. The harshest controls came in 2010 when the government restricted the number of apartments that an individual could purchase.

Property prices are a sensitive subject everywhere, and China is no exception. The government presses the brakes if the prices are speeding too fast and pushes the accelerator if property construction flags too much so as to threaten the overall economic growth.

This government intervention makes asset values volatile in both equity and debt markets, and raises the cost of capital to the sector.

Some investors have also been scared away by stories of oversupply and ghost cities. The property development business model, by definition, consists of a long operating cycle, and there may be genuine demand/supply imbalances, as in any other industry, but the overwhelming majority of Chinese properties are built in response to actual demand from a rapidly urbanising population. The same goes for talk of speculative buying, when the reality is that most of the properties are bought for self-occupation. Buyers have to put up a minimum 30% down-payment, they are not over-leveraged and there is no subprime lending.

WHEN IT COMES to investing in Chinese property bonds, one should realise that there has already been one level of filtering – only those companies large enough to go through a rating process and the expense of issuing offshore actually end up selling dollar bonds. They are all listed offshore, most of them in Hong Kong, and are subject to audits and disclosures that go with the listing status. The additional scrutiny from equity analysts and investors that comes with listing also offers additional information for bond investors.

There has not been a single default in the sector so far, and only two distressed exchanges in 2009, both at 80 cents to the dollar. Some companies did go through financial distress during previous sector downturns, but they managed to sell land or unfinished projects to stronger players and stave off default.

This is not to argue that we would never see a default in the sector. We will, sooner or later. But the sector has genuine fundamentals, strong and weak players, and saleable assets that can be realised in times of distress.

So, how should one approach investments in Chinese property bonds? First of all, investors need to be prepared for the volatility that comes with the regulatory changes. Any crash in value following a regulatory tightening offers an opportunity to pick up the higher-quality bonds at more attractive prices. In fact, such moves also enable the stronger players to buy out the weaker ones or to acquire assets from the struggling players, and increase their market share.

The current downturn in the market is no different. It is true that the stock of unsold property is running above average; that the leverage has increased in the last 12-18 months in response to slowing sales; that margins are under pressure due to the pressure to liquidate stock; and that some of the weaker companies are likely to experience a liquidity crunch in the next 12-18 months, unless they slow down their expansion. But the current downturn is also an opportunity to pick up bonds issued by stronger companies, which will benefit from the tight conditions in the sector. The challenge is reading the credit fundamentals carefully enough to identify the winners.

Asian bonds have had a good run so far this year, producing a total return of 7.8% according to J.P. Morgan Asia Credit Index (JACI). But, looking back over the last three years, yields and spreads have steadily declined, so much so that “high yield” has become an oxymoron!

That has raised the question in the minds of many people: Is there a bubble in Asian fixed income?

The “B” word has been applied variously to different asset markets, such that it has become an amorphous thing … one that everyone talks about all the time, but no one knows precisely what it means!  Let us try to keep the dreaded word in perspective for our discussion. One definition of a bubble is when the prices are far in excess of the fundamental value of the assets. Another way to look at a bubble is as an unsustainable and fast rise in prices. Either way, a bubble carries the potential to hurt investors when it eventually suddenly bursts.

Keeping this in mind, let us examine the evidence in the Asian U.S. Dollar bond markets. The first evidence for the existence of a bubble is the contraction in both yields and spreads. It is true that the current yield to maturity of 4.6% for JACI seems too tight, particularly when compared with the high level of 11% during the Global Financial Crisis. But if we disregard the spike in yields during the GFC and the period when the interest rates were slashed in its aftermath, average yields have moved in a narrower range of 4.2% to 5.5% in the last four years and the current yield is near the middle of this range.

Similarly, if we consider the history of spreads, the current spreads over Treasury of 243bp appears tight when compared with the GFC high of over 800bp. But in the last four years, they have ranged between 214bp and 450bp; and if we disregard the mini-spike during the European sovereign crisis, they have moved between 214bp and 320bp. Compared to this range, the current spreads do not appear so alarming. In fact, they are more than double the tight levels of 109bp reached in 2007 before the GFC.

Compared to the U.S. domestic bonds, Asian spreads still offer value. Asian investment-grade corporate bonds, for example, trade at 180bp over Treasury, while spreads for U.S. industrial bonds with equivalent credit quality and maturity trade at spreads of 100bp.

When we consider the fundamentals, another key factor is the default rate for bonds. According to Moody’s, the global high-yield default rate was 2.1% for July 2014, well below the historical average of 4.7%. In Asia-Pacific, Moody’s predicts a default rate of 3.3%.

While such low default rates are one of the supports for the current tight spreads, we must remember that they are themselves partly the result of loose liquidity conditions and easy monetary policy. That brings us to the one of the key reasons to question whether the Asian bond market might collapse in a bubble-like fashion when rates start rising and liquidity begins to ebb. It is doubtless true that the bond valuations have benefited from the falling rates. In 2014 so far, of the 7.8% return generated by Asian bonds, 3.6% has come from a fall in Treasury yields and the rest from tightening spreads.

This comfortable environment would change as the Fed starts raising rates in the second half of 2015. Not only will longer-duration bonds face capital losses, but weaker companies would find it more challenging to roll over maturing debt – in turn leading to higher default rates.

It is based on such fears that some predicted a mass migration of funds from fixed income to equity, calling it the Great Rotation. But so far, in the Asian bond markets, there has been scant evidence of such a shift. New issue volumes are touching record levels, with USD 120 bn of new bonds so far this year, representing a growth of 35% over the same period last year. Although private banks have taken up only 9.7% of new issues this year, down from 16.2% and 13.9% in the last two years, the gap has been more than adequately filled by institutional funds.

At a very fundamental level, Asian economic growth is holding up reasonably well, although all eyes are on China’s and India’s growth rates to see how these two economies perform. For the Asian bond market, China is a key variable, particularly the Chinese property sector.

So, finally, is there a bubble or not in Asian bonds? Although Asian bond valuations are stretched at the moment, they are not beyond belief and entirely divorced from fundamental factors. Some of the supporting factors such as rates and high liquidity will diminish over the next two years, but I believe the correction would be orderly and not a sudden collapse. Asian bond valuations may be tight, but they are not a bubble.

One year ago, when Bernanke first mentioned the possibility of tapering, the asset markets took fright that the Fed would take away the punch bowl. The U.S. Treasury yields spiked immediately, leading many commentators to predict an Armageddon in the fixed-income markets resulting from a combination of rising rates, falling asset prices, shifting of funds to equity markets.

However, the reality so far has turned out to be very different. As the Fed began the actual tapering, interest rates have gone down this year. The 10-year Treasury yields ended the last year at 3%, but have since retreated to 2.6%, reflecting the hesitant performance of the U.S. economy as well as the additional monetary stimulus from Japan and the possibility of a stimulus from the ECB.

Neither has the “great rotation” out of fixed income into equities materialized. The equity funds covered by EPFR have received USD 46 bn of inflows this year, while the bond funds have gathered USD 84bn. It is interesting to note that both figures are lower than those recorded in the same period last year (USD 140 bn for equity and USD 100 bn for bonds). However, these figures mask a striking contrast between developed-market and emerging-market funds: the former gained USD 68 bn in equity and USD 90 bn in bonds, while the latter lost USD 23 bn in equity and USD 7 bn in bonds.

If one were to observe the Asian USD bonds, however, one would certainly believe that the good times are still rolling on. New bonds worth USD 80 bn have been issued in the first five months of 2014, at par with the corresponding period of last year. (Note that the chart below includes EUR and JPY as well).

Asian USD bonds have so far produced a total return of 5.6% (see table below), split roughly equally between the returns from the falling US Treasury yields and the tightening spreads. Split another way, coupons have generated about 2% so far, while rising bond prices (both due to US Treasury and spreads) have produced 3.4%. The table below shows that investment-grade has outperformed high-yield so far. This is mainly thanks to the concerns over the Chinese property credits and the impact of the falling coal prices on Indonesian mining credits.

This total return looks quite respectable when viewed against the overall equity market performance. MSCI Asia ex-Japan equity index is up 2.8% this year, thanks mainly to emerging markets such as India. Hang Seng, on the other hand, is flat.

Regular readers of this blog may remember our recommendation for this year to overweight high-yield. We still expect high-yield to outperform investment grade. While we still believe in that prognosis, investors would be well advised to follow two other broad strategies:

• Stick to better quality names: While liquidity is still comfortable, there will come a day when companies with lower credit quality will find it difficult to refinance themselves. Already, bonds with lower ratings have underperformed: as the chart below shows, the best returns have come from “BBB” bonds, while the worst have come from “B” and “C” rated bonds.

• Control the duration: While the decline in the interest rates have taken many people by surprise, thereby enabling the longer-duration paper to do well, it is difficult to conceive of the rates falling further. In fact, discussions have already started in the Fed about when the first rate increase should take place. At this juncture, it is better to shorten the maturity of the portfolio towards five years rather than longer. Many perpetual bonds look increasingly riskier, unless the issuer has a strong incentive to call the bonds earlier.

In its short six-year life, the offshore Renminbi bond market in Hong Kong, also called ‘Dim Sum’ or ‘CNH’ bonds, has emerged as an investors’ favorite. A range of issuers, including the Chinese government, Chinese banks and companies and foreign companies, have issued debt in this market, raising the total outstanding value to over RMB300bn for bonds and another RMB250bn for certificates of deposit.

From the investors’ point of view, CNH bonds were attractive because their total return came from not only the underlying bond yield, but also the expected appreciation of the Renminbi. In addition, CNH bonds were less volatile than Asian USD bonds, although less liquid too. Some investors felt they could park their money in CNH and enjoy a steady and superior return.

Investors’ expectations were validated as the Renminbi had climbed steadily at an annual rate of 3.4% against the dollar from August 2010 until January 2014, after being frozen from 2008 to 2010 during the peak of the financial crisis.

But recent developments have shaken the expectations. Since January 2014, in just over 60 days, the Chinese currency has weakened 2.8%. On March 15, the People’s Bank of China widened its daily trading band to 2% around the central value from the previous 1%, raising the possibility of further depreciation in the currency. Whether the currency falls further or not, these changes have raised the volatility of the currency.

The reasons for the currency fall are not far to find. The Chinese economy has been slowing perceptibly over the last two quarters. There are rising concerns over the significant amount of credit creation in the economy. These concerns have led to the exit of some hot money from the currency. There is also the possibility that the currency depreciation may actually be welcomed by the Chinese authorities in the face of slowing exports from China.

Whatever the reasons, the currency fall has shaken one significant support to the CNH bond market. But the surprising fact is that the CNH bond values have hardly budged in the last two months (see table below). Reflecting that, the HSBC CNH index has held steady from 107.45 at the beginning of the year to 107.81 on March 21. One reason could be that investors, particularly the private-bank investors, view the currency weakness as temporary.

Is the CNH market still attractive for investments, despite the currency moves? To answer that question, we have compared several names that have issued in both the CNH and USD bond markets (see table below). It is evident that, for several investment-grade Asian names, CNH bonds offer higher yields for the same or shorter maturities. Even after accounting for the cost of hedging the currency exposure, the CNH market offers a pick-up of 50 to 100 basis points over the USD market. However, for non-investment-grade names, the USD market offers better yields.

It is clear that the CNH market has not lost its allure for investors even after the recent currency gyrations. It will take much more than a couple of months of currency weakness to shake their faith.

Last week, I participated in three panel discussions in the South East Asia Borrowers and Investors Forum in Singapore. In my panels and throughout the conference, one word kept reverberating: “Tapering.” Unknown and unused in the financial markets previously, the word has acquired a magical significance ever since Bernanke uttered it in May.

The fear of tapering took a slightly different form in the context of local-currency bonds as opposed to USD bonds from Asia. In case of USD bonds, the question was the potential for fixed income as an asset class to produce returns in the face of rising rates; in case of local-currency bonds, the issue was linked to the potential for fund outflows from emerging-market economies, triggering volatility in currencies, equities and bonds alike.

Over the next few months, there are many flash points for emerging markets, including India, Indonesia and Brazil. The first is the next round of negotiations in the US for the debt ceiling in January. Then comes the potential beginning of tapering by the Yellen Fed, some time in the first quarter. After that, the national elections in India (before May 2014), the presidential elections in Indonesia (July 2014) and the general elections in Brazil (October 2014). Each of these events has the potential to keep alive the volatility that we have witnessed this year.

The current mood in the fixed-income markets is one of relief (that the tapering is not imminent) mixed with foreboding (that rates are eventually set to rise further). At the moment, the market is still in a healthy state, as evidenced by the flow of new issues and the stability in credit spreads.

Beyond the next few months, the shape of the fixed-income markets will depend on the speed with which interest rates normalize. I believe that even when tapering gets underway, it will be a carefully managed process by the Fed. The Fed has made it abundantly clear that any withdrawal of monetary stimulus will be data-dependent. The Fed has a lot of leeway in deciding the speed of tapering. While it may start with a reduction in QE of USD 10 billion a month, it may not continue to taper at a rapid pace if the economy begins to falter. The Fed will also be watching the behavior of long-term rates, both as an indication of the market reaction, and more importantly, as a key variable that could affect the mortgage rates and the housing recovery.

As a result of this carefully managed process of tapering, fixed income investors should be able to adjust their portfolios over the medium term. If there is a sudden jolt to the rates, like it happened during May-June 2013, leading to losses in the portfolio, there is likely to be a temporary pullback. If rates adjust gradually, over the next 2-3 years, there will be enough breathing space for investors to realize their maturing investments and reinvest them at higher yields, and thereby adjust their portfolios for rising rates.

Over the course of 2013, many factors might have been expected to lead to a slowdown in Asian dollar bond issuance. First of all, interest rates have risen from their lows in 2012, with the yields on 10-year Treasuries higher by over 100bp. While everyone knew that interest rates had to normalize at some point, the rise in yields brought that fear to the front and center of everyone’s thinking. Then, in May, Bernanke raised the possibility of slowly withdrawing the monetary accommodation with his discussion of “tapering.” Third, for the last three weeks, we have tried to grapple with the possibility that the U.S. government may have to cut back on paying for its commitments and expenses if the debt ceiling is not raised by October 17.

In the midst of all this, Asian bond markets have had a great year in terms of new issues. So far this year, by our count, over USD 110bn worth of dollar-denominated bonds have been issued by Asian issuers. Month after month, in terms of issue volumes, 2013 has outpaced 2012 (which itself was a record year).

It must be noted that this year’s record volumes are despite the lean period in June to August, when only USD 7bn was issued in the full three months. Although this period is usually a low season, this year’s volume was much below the USD 18bn issued during the same three months last year. 

What accounts for the robust state of this market? Are investors blithely indifferent to the ructions around them?

The first thing to recognize is that much of the new issues are simply replacement for maturing bonds. This becomes clear if we consider the increase in the net market value outstanding at the end of the last few years (see chart below). This year, the market value has risen by USD 30bn – not a bad number, but still a slower pace of growth.

The figures nevertheless show that net new money has been available for bond issues, despite the repeated challenges. From the issuers’ point of view, the cost of funding is still attractive. Yields of 2.6% on 10-year Treasuries are still near the multi-decade lows, and the bond spreads are also reasonable although higher than the pre-crisis levels. From the investors’ point of view, Asian dollar bonds still offer a pick-up over comparable US domestic issues, even among investment-grade bonds. 

At this stage, it is fair to say that Asian dollar bonds have become a legitimate, large asset class with a diversified pool of issuers and sufficient liquidity for investors. Asian dollar bonds represent roughly 40% of all emerging market dollar bonds. Even as interest rates continue their upward journey in the medium term, we believe that institutional money would still be actively engaged in this market.