Asian fixed income continues to be an under-owned asset class in relation to the region’s GDP and growth contribution. Perhaps this is due to Australian investor wariness over the asset class. However, we think that Australian investors are actually missing out on opportunities.
Given the current low growth and low interest rate environment, most of the Asian region offers superior growth prospects than developed markets and better debt dynamics. The region is seeing an improving credit rating profile contrary to many of the movements in developed economies over the past few years. Asian credit fundamentals are stable and it is a growing asset class that offers attractive yields and diversification from developed markets. In addition, according to our analysis, detailed later in this paper, including an allocation to Asian fixed income alongside Australian fixed income can boost portfolio returns without increasing risk.
Asian debt markets continue to grow quickly
The Asia ex-Japan region comprises a diverse group of economies and bond markets at different stages of development. While the Asia ex-Japan bond market may represent only a fraction of developed world bond markets, it is growing rapidly, with about USD 8.7 trillion in outstanding bonds or 57% of the region’s GDP[1] (see chart 1).
Source: Bloomberg, IMF World Economic Database, AsianBondsOnline, SIFMA.org, HSBC, European Central Bank
In addition, the Asian region offers better growth prospects than developed markets. According to Standard Chartered Research[2], the forecast 2014-2030 annual GDP growth for China is 5.9%, India 6.7% and the rest of Asia ex-Japan 5.5%. Over the same time period, the average annual growth for the rest of the world is expected to be 3.0%, for the US 2.3% and for the European Union 2.0%. Led by China, Asia ex-Japan’s share of the global economy is rising, offering increasing opportunities for fixed income investors.
Asian local currency bonds grew significantly following the 1997 Asian financial crisis (see chart 2), with strong domestic support for the asset class as the economies expanded with high savings rates.
Foreign investor participation has also grown as Asian governments continue to reform their markets and improve foreign investor rules, making them more accessible and attractive. For example, as of December 2004, less than 5% of Indonesian, Korean, Thai and Malaysian bonds were held by offshore investors[3]. As of March 2014, offshore holdings had increased to 33.6% of Indonesian bonds, 10.5% of Korean bonds, 116.2% of Thai bonds and 30.8% of Malaysian bonds.
Asian economy fundamentals substantially improved
Since the Asian Financial Crisis, external debt in the region has fallen to more sustainable levels. Fiscal deficits in the region are now mostly below 4%, while some economies, such as Hong Kong and Singapore are in surplus. In addition, Asian economies have accumulated substantial foreign currency reserves, allowing governments the flexibility to manage currency volatilities, and their current accounts are largely in surplus.
As of mid-2014, most Asian sovereigns were rated as investment grade by Standard & Poor’s (S&P), Moody’s and Fitch. This is much higher quality than the broader emerging market countries, with Singapore and Hong Kong leading the pack with comparable ratings to the UK and US.
In the current environment, investors are on the hunt for yield. And yet many are overlooking the Asian market despite the fact that Asian bond yields are higher than developed markets. One of the most commonly used indices to represent the Asia local currency bond markets is the HSBC Asian Local Bond Index (ALBI), which tracks the total return performance of a portfolio consisting of local currency denominated, high quality and liquid bonds in Asia ex-Japan. The average return of the HSBC Asian Local Bond Index from 2002 to July 2014 was 7.27% pa.
In addition, from 2001-2013, the annual calendar returns of the HSBC ALBI have only been negative in one year – 2013. Even in 2008, at the height of the GFC, the index returned 1% (see chart 4).
Currency has contributed to the strong performance of Asian local currency bonds. However, as macro-economic fundamentals remain strong, with most countries’ current accounts in surplus, we still expect Asian currencies to appreciate in the long term. Although there is a potential risk in a broad strengthening of the US dollar as the US Federal Reserve starts to remove its easy monetary policy, the Eurozone and Japan are expected to maintain their current easy monetary policy. We believe that Asian currencies are in a better position relative to other regions with fewer geopolitical risks and volatility compared with other emerging countries. India and Indonesia, two of the worst affected Asian countries during the ‘taper tantrum’ in 2013, have implemented policies to address current account deficits and with their new elected governments are viewed positively from a reform perspective. This should reduce their vulnerability when US rates start to rise.
Asian bonds also offer these relatively good historical returns with moderate volatility (see chart 4). Compared with the broader emerging markets, Asian credit and local currency bonds have demonstrated much lower volatility over the past 10 years.
Asian credit – attractive spreads with lower defaults than other EMs
Asian hard currency bonds (USD-denominated) have grown steadily as more issuers tap the offshore market and these are dominated by credit issuers (including corporate and quasi-sovereigns) at 85% of the market. The JP Morgan Asia Credit Index (JACI) tracks the total return performance of a portfolio consisting of USD-denominated bonds issued by Asia (ex Japan) sovereigns, quasi-sovereigns, banks, and corporate.The total market capitalisation of the JACI has increased from USD 143 billion in 2005 to USD 522 billion as of June 2014[4]. In terms of credit quality, investment-grade issues dominate at USD 400 billion, with USD 122 billion of high yield issuance.
Although investors may be worried about rating downgrade and default risk for Asian corporates, chart 5 below shows that this is lower than for other regions where default rates are higher. Although Asian high yield default rates are expected to inch up in 2014, we expect them to remain below the emerging market average.
Asian credit spreads are also more attractive than for US and European credits, now for high yield as well as investment-grade. As of 31 July 2014, the approximate spread pick up for an A rated Asian credit was 35 bps over US and European credits, while a BBB rated Asian credit saw a spread pick up of about 55 bps over US and 65 bps over European credits. In terms of high yield credits, as of the same date, the approximate pick up for a BB rated Asian credit was 80 bps over the US and 112 bps over Europe, while a B rated credit achieved about 235 bps over the US and 210 bps over Europe. In our view, spreads are at attractive levels that can offset impact of increasing risk-free rates.
Returns for the JACI Total Return Index have been largely positive over the past 12 years, with only two periods of negative return – in 2008 during the height of the GFC when credit globally suffered and in 2013 mainly due to the sharp rise US Treasury yields. Although JACI investment-grade credits suffered in 2013, JACI high yield actually offered a positive return (see chart 6). Higher bond yields were able to offset the impact of rising rates and wider spreads.
Including Asian fixed income in an Australian portfolio can boost returns without increasing risk
Asian fixed income doesn’t feature heavily in the average Australian investor’s portfolio. However, our analysis shows that including an allocation to Asian fixed income alongside Australian fixed income can boost returns without increasing risk.
We compared a range of Australian fixed income indices with Asian fixed income indices as part of our analysis. Chart 7 shows the risk/return for JACI, JACI high yield, JACI investment grade and JACI corporate compared with the risk/return for the UBS Australia Composite Bond Index, the UBS Australia Supranational/Sovereign Index and the UBS Australia Credit Index.
Although the JACI and its sub-indices offer high returns over the period, the volatility is also much higher. JACI high yield returned 11.79% over the period, but with 8.98% annualised volatility. Over the same period, the UBS Australia Composite Bond Index delivered a return of only 6.43% but with a much lower volatility of 3.29%.
Using our efficient frontier analysis, we studied various combinations of Australian and Asian fixed income indices in an example portfolio. Based on historical data, this analysis aims to create a set of optimal portfolios that would have offered the highest expected return for the given level of risk.
First we looked at the UBS Australian Credit Index, which offered a slightly higher return (6.85%) with lower volatility (2.24%) than the UBS Australia Composite Bond Index over the period studied. The analysis focused on the combinations that would have offered the highest return while maintaining the 2.24% risk level. The key is the amount of each allocation – for example, we included a much smaller proportion of JACI high yield to maintain the 2.24% risk level, although this combination still offered the highest return with an 84 bp pick up over the UBS Credit Index.
We also analysed what would happen if we combined Asian fixed income with the UBS Australia Composite Bond Index while maintaining its historical risk level over the period of 3.29%. A similar picture emerged, with the optimal portfolio combination of the UBS Index and the JACI Total Return Index offering a substantial 177 bp pick up over the return of the UBS Index on its own.
Obivously, to achieve these results would require perfect foresight to implement, but it does show the potential upside of combining Asian and Australian fixed income within a portfolio.
Asian fixed income offers diversification benefits
Another advantage of Asian fixed income is the diversification benefits that it offers. The correlation between Asian and Australian bond markets is fairly low, which could help manage overall portfolio risk and reduce volatility (see table below).
Sector diversification is another consideration, with the JACI offering Australian investors exposure to sectors that aren’t or aren’t well represented in the Australian markets (see chart 8).
Conclusion
Favourable macroeconomic conditions, higher growth trends, enhanced corporate transparency and improvements in sovereign credit ratings indicate that Asian economies are likely to continue to experience robust growth. In the current ‘lower for longer’ interest rate environment, strong capital inflows into Asian bond markets due to the hunt for yield should continue for some time. In our view, Australian investors are missing out on the opportunities that Asian fixed income offers, particularly the attractive yields and diversification from the Australian market.
By Bertram Sarmago, Investment Director – Fixed Income (Singapore), Nikko AM
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[1] Source: Bloomberg, IMF World Economic Database, AsianBondsOnline, SIFMA.org, HSBC, Deutsche Bundesbank. Bond market size as of June 2014 except for Taiwan and India (mid-2013 estimate by HSBC), US (as of March 2014).
[2] Standard Chartered Research – The super-cycle lives: EM growth is key , 06 November 2013
[3] Source: AsianBondsOnline
[4] JP Morgan, as of 30 June 2014
