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 in IFR Asia magazine

One of the key constraints for the Indian economy is the accumulation of non-performing loans in the banking system. Recent figures from the IMF show that, at 5.9%, India’s gross non-performing loans as a share of total loans are the highest in Asia. Including restructured loans, the figure exceeds 14%.

As banks groan under this burden, they are unlikely to be able to support the lending growth required for the economy to pick up. The Reserve Bank of India has taken the first step towards a solution by conducting asset-quality reviews and insisting that all the non-performing loans be recognised for what they are. It has imposed a deadline of March 2017 for the banks to properly classify loans and make provisions.

While this may increase the stress on the profitability and capital ratios of the banks, it is better to accept the truth than to brush it under the carpet. The capital ratios of Indian banks are already among the lowest, according to IMF, and will come under further stress as the banks go through the inevitable pain. While the government has allocated some funds to recapitalise banks, this is by no means sufficient.

Apart from pushing for greater transparency, the RBI has allowed banks to convert loans into equity with a stipulation that they have to find a buyer for the shares within the next 18 months. The challenge for the banks is to convert the debt to equity at a high valuation, manage the companies in the interim, and identify a buyer. The RBI permits the banks to sell as little as a 26% stake while holding the rest, but potential buyers may not like keeping the banks as co-owners for an extended period.

The RBI has also allowed banks to refinance loans to the infrastructure sector for 25 years with refinancing or restructuring every five years. The question is whether banks will apply this option to viable loans or to mask problems.

However, none of these solutions is a genuine attempt to improve the viability of troubled borrowers. If India’s bad loan problems are to be resolved in a meaningful way, a host of supporting systems need to be developed. The recently enacted bankruptcy law goes some way in offering solutions for the resolution of insolvent companies, but more changes are required.

First of all, banks need the freedom to deal with problem loans in the best way possible. Currently they are averse to writing off loans or to sanction additional credit for troubled companies for fear of being accused of underhand dealings. The current RBI regulations are far too constraining for them to try to revive distressed borrowers, as they impose a time limit on re-sales of equity shares acquired through debt swaps, lay down the equity valuation method, and specify the minimum percentage to be sold.

India also needs to develop a strong culture of evaluating credits before the loans are sanctioned and for monitoring the borrowers for early-warning signals of trouble. In this context, it is interesting to note that it is not small-scale industries that have led to this massive accumulation of bad loans, but the medium and large-scale borrowers. So the question can justifiably be asked why the banks tolerated the build-up leverage and not take action sooner.

The concept of independent insolvency professionals introduced in the new bankruptcy law is a positive move, but they need to come from a variety of industrial management, finance and turnaround backgrounds, rather than merely the legal profession. This will happen only if banks are willing to entrust management of troubled industries to turnaround professionals rather than lawyers with expertise in dissolving companies, backed by appropriate incentive structures. For example, banks may agree on an incentive compensation based on an objective measure of improving the value of the borrowers’ business such as a multiple of Ebitda or on specific actionable measures such as completion of specific projects.

Although asset reconstruction companies have existed in India for many years, they are modest in size compared to the scale of the problem. They have also enjoyed a favourable system of putting up a cash outlay of only 5% (recently increased to 15%) and charging a management fee of 1.5%-2% of the asset value. In addition to this model, other models of outright sales, incentive payments and sharing of recovery values would encourage reconstruction companies to maximize recoveries. Unlike China, India could also consider investing public funds in asset reconstruction companies in order to provide a speedier resolution to the problem.

​Any amount of tinkering with rules on recognition of problem loans and provisioning is not likely to lead to a genuine revival or resolution of bad loans. To achieve that, the mindset has to change across the entire range of stakeholders, including banks, turnaround funds, professionals, and even the government.

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.

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.

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.

Within Asia, the north-eastern countries (Japan, Korea and Taiwan) have progressed much faster in the last 50 years than the south-eastern countries (Indonesia, Philippines, Thailand and Malaysia).

Would you believe that, in 1950, Philippines was richer than Korea and Taiwan? Or that there was hardly any difference between Taiwan, Korea, Indonesia and Thailand? Or that China was lagging Indonesia and Philippines? Here are their GDP per capita figures for 1950: Japan $1,873, Philippines $1,293, Taiwan $922, Korea $876, Indonesia $874, Thailand $848, China $614, India $597*. Today, Japan, Korea and Taiwan have all ascended to the developed country status, while Indonesia, Philippines and Thailand have been left behind. The question is why.

In his latest book, "How Asia Works", Joe Studwell tries to answer that question. He identifies a magic formula with three ingredients: land reforms; state-supported manufacturing development; and state-controlled  financial sector being harnessed to support manufacturing.

The first one, land reforms, consists of restructuring agriculture  into labor-intensive household farming, which maximizes agricultural productivity by making use of the excess labor available in the initial stages of development. This results in a surplus that creates demand for goods and services and sets the stage for the second initiative, development of state-supported manufacturing.

State-supported manufacturing means channeling investment towards manufacturing rather than other types of businesses. This creates productive jobs for workers with limited skills as they migrate out of agriculture. For this process to be successful, Studwell lays down two essential conditions: rapid learning of advanced manufacturing technologies and subjecting manufacturing to export discipline to make sure that only the globally competitive industries survive.

The third intervention is to control and harness the financial sector to provide the necessary capital for the agricultural and manufacturing development, rather than other types of businesses, including services and personal consumption. The financial sector could also be used as a tool to ensure export discipline for the manufacturing industries.

Well, that's it - the magic formula. Having explained this right upfront in the foreword, Studwell spends the rest of the book mainly presenting the historical evidence for his theory. Much of his evidence is anecdotal and historical; not much of statistical tables and charts, but a lot of narrative economic history. In between, the narrative is interspersed with his observations from his travels in some of the countries, in so far as they are related to his theory.

In general economic commentaries, we do not generally read much about state-directed manufacturing and finance as elements critical to economic development. Hence Studwell’s theory is an interesting one. But I could not help questioning it as I read along.

One issue is whether these historical lessons are still relevant. In other words, can the lesser-developed countries start implementing this formula today and achieve development? For instance, it can be argued that what is holding back India are misdirected and wasted subsidies, corrupt and inefficient bureaucracy and the plutocratic political class. For India, the solution has to start with dismantling the current economic and political structures rather than more state-directed support for selected manufacturing industries or state-directed lending for farming and manufacturing.

In many places, the book comes across like extolling central planning and state control. Studwell praises the economic model followed by Park Chung-hee, Korean dictator from 1961 until his assassination in 1979. It so happened that Park’s economic policies contained some of the positive elements such as manufacturing development, rapid technological acquisition and development of globally competitive industries, which helped Korea’s fast economic development. But central planning and government control over the economy can easily turn into crony capitalism, as it happened in Indonesia’s Suharto period or in India until the economic liberalization of 1991. Russia is another ongoing example of how state control has not managed to lay the foundations for sustained economic performance – the country remains sorely dependent on oil and gas revenues. The point is that, for every one successful state-directed economic development, there are myriad examples of misdirected, corrupt and failed attempts of state-directed economy.

It is not clear to what extent Studwell’s model applies to China’s incredible rise in the last four decades. While China has followed the export-led growth model and turned itself into the world’s factory, it has yet to prove its ability to acquire and develop advanced technologies. Although Studwell provides some figures about the growth in the total profits earned by state-owned firms, there is a lot of other evidence that their return on capital invested is much lower than that achieved by private firms. It is then no wonder that China's incremental capital-output ratio has been rising. China today stands at a crossroads, when it needs to shift from export-and-investment-led growth to domestic-and-consumption-led growth.

A good question may be worth more than one good answer. As such, books should not be judged solely by their ability to provide answers. In that sense, Studwell’s book provokes many interesting questions. For example, how is India going to achieve economic prosperity and provide jobs to its expanding young population without developing its manufacturing sector? Its vaunted information technology sector has created 3m direct jobs, hardly enough to scratch the surface, leave alone making a dent in the country’s employment levels. While Indonesia has ridden the commodity boom for the last 10 years, how is it going to climb further without a coherent competitive strategy? Malaysia has got stuck in the middle-income trap without a clear strategy of how to develop further.

As Studwell points out, the economic profession seems to have adopted the mantra of free market, the government’s role being only to build the infrastructure, provide the legal and institutional framework and set the monetary policy, leaving the manufacturing and services sectors to decide their growth strategies. This book raises interesting questions about whether governments should legitimately play a more interventionist role in fostering development.

I had immensely enjoyed Studwell’s earlier book, “Asian Godfathers”. It was a riot of a read about Asia’s business tycoons and their escapades, although with a solid message about how they had cornered the economic systems to their own advantage. “How Asia Works”, on the other hand, is much more of a slow and difficult read.

* "All countries compared for Economy> GDP per capita in 1950, Angus Maddison. Aggregates compiled by NationMaster." 1950.
<http://www.nationmaster.com/country-info/stats/Economy/GDP-per-capita-in-1950>.

Asian dollar bonds ended in the red last year with a total return of -1.3% according to the JP Morgan Asia Credit Index (JACI). However, this figure masks a large variation between different segments. At the low end, investment-grade sovereigns lost 8.2%, while at the high end, high-yield corporates produced a return of 4.3%. Within high-yield corporates, Chinese property credits were the best performers, earning a return of over 7%.

The negative return was mainly due to the pick-up in Treasury yields, particularly after May 2013 when talk of tapering emerged. Spreads on Asian bonds performed well, with the overall spreads steady at 260bp despite the ructions in market.

The outlook for 2014 will again be dependent on both Treasury yields and the underlying credit fundamentals. With the Fed poised to taper the quantitative easing over the course of the year, and as the US economy continues to accelerate, we can expect further increases in Treasury yields. After the 10-year Treasury yields have already touched 3%, they are unlikely to rise at the same pace as last year, and a rate in the mid-3% area for 10 years seems appropriate for the end of 2014.

Asian spreads are still higher than their pre-crisis levels (see chart below). In addition, the table below shows that Asian dollar bonds provide a yield pick-up over US bonds for same/higher ratings and shorter maturities. The yield pick-up is about 30-60bp for investment-grade and about 180bp for high-yield bonds. Given these factors, there is scope for a further contraction in Asian spreads by 25-50bp. This should cushion the impact of the expected rise in Treasury yields.

The other supporting factors for spreads are the likely low default rates and steady credit ratings in Asia. The underlying economic picture should also be supportive for credit quality – the US economy is likely to further pick up this year, Europe is expected to limp back to stability after recession, and Asia should be supported by the improving external economic environment.

If Treasury yields rise and spreads contract, the net effect could still lead to a positive return for Asian credits as a whole. The average yield on Asian bonds is 5.3%, composed of 4.6% for investment grade and 7.5% for high yield, according to JACI. As long as Treasury yields do not rise steeply, the overall return should be close to the yield. Of course, the net return depends on the extent to which Treasury yields rise.

For instance, if 10-year Treasury yields reach 3.5% and spreads contract 25-50bp, then the total return could reach close to 4%.

With the Asian credit universe, high-yield corporates are once again set to outperform investment-grade credits. High-yield bonds should do well as long as default rates stay low and the refinancing environment remains comfortable. Hence it makes sense to overweight high-yield bonds in Asia.

That brings us to the concept of the two interest rates: one that applies to the investments and the other to leveraging the portfolio. Over the course of this year, as the Fed tries to taper down its quantitative easing, longer-term interest rates are set to rise further, negatively affecting the market values of bonds. Hence, it is important for investors to focus their portfolios towards the short-to-medium-term maturities of, say, around 5-7 years.

The short-term interest rates, on the other hand, are likely to stay low, as the Fed will continue to keep the short-term rates close to zero for an extended period of time, perhaps until the end of 2015, and raise the rates only in small steps after that. Investors can use this to leverage their portfolios by borrowing short-term funds.

There is one final element in the construction of the portfolio strategy in Asian credit, and that is to choose credits carefully with regards to their fundamentals. While the refinancing environment may be reasonably easy in 2014, the same cannot be said of the years after that. As liquidity tightens in 2015 and as cost of funds rise, not all the borrowers will find it easy to refinance maturing debt. That in turn could lead to mark-to-market losses for weaker credits, perhaps later in 2014 or beyond. Investors must position their portfolios by carefully avoiding such weaker credits.

So, let’s put together the main elements of the suggested investment strategy in Asian credits:

1. Keep the portfolio maturity towards the lower end, i.e., 5-7 years.
2. Continue to employ leverage to improve returns.
3. Overweight high-yield over investment-grade.
4. Choose the credits carefully and avoid fundamentally weaker credits, even if their yield is attractive.

By carefully managing the portfolio, it is possible to generate returns of up to 8-10% from Asian dollar bonds for 2014.