Asian bonds take centre stage in Asia — Chia Tse Chern
APRIL 21—Asian bonds are set for explosive growth over the next two decades.
Yet as investment conversations go, Asian bonds have traditionally taken a back seat to the more popular asset classes such as equities, commodities, real estate and occasionally foreign exchange.
Perhaps the arcane bond mathematics boggles the minds of investors, or perhaps it is due to bonds' reputation of dull returns. This is about to change.
A combination of demographics, good historical performance, low volatility, relatively cheap valuations and low default rates will ensure that Asian bonds grow strongly and become a dominant asset class in the region within the next two decades.
The Asian (excluding Japanese) bond market can be broadly divided into two main markets - the Asian local currency bond market and the Asian USD bond market. The Asian local currency bond market stands at a significant US$6.5 trillion (S$8.1 trillion) - doubling in the last five years. This is a fragmented market as each Asian local currency bond has unique regulations, taxation and idiosyncrasies.
By contrast, the Asian USD bond market is smaller and more homogeneous. Valued at about US$470 billion, the Asian USD bond market has grown 50 per cent over the last five years.
Being United States dollar denominated, capital gains and coupon income are, therefore, not subjected to taxes. Furthermore, prices of Asian USD bonds are susceptible to changes to the US treasury, interest rate and fluctuations of the US dollar.
Asian USD bonds enjoy better liquidity and market depth as they attract a diverse set of investors and corporate issuers. Within the Asian local currency market, the offshore yuan bond market is emerging rapidly as a potential rival to the Asian USD market in terms of market liquidity and depth.
An ageing Asian population is likely to be responsible for the Asian bond market becoming a major asset class in the next two decades. Asia is facing an unprecedented pace of population ageing even as the region is enjoying a rapid pace of wealth accumulation.
According to the United Nations, the proportion of Asians older than 65 is expected to triple to 18 per cent by 2050 from 6 per cent in 2000, pushing the number of people in this age group to 857 million from 207 million.
As Asia's population ages, Asian bonds will gain popularity as more emphasis is placed on capital preservation and steady interest income accrual.
A compelling reason to invest in Asian bonds is that it has had better returns and lower volatility compared with Asian equities over the last five years.
Asian bonds (using JP Morgan Asia Credit Index as the benchmark) rose 40.4 per cent in USD terms during the 2007-11 period, while Asian equities (using MSCI Asia ex-Japan as the benchmark) rose only 14.5 per cent over the same period.
Even when adjusted for the 18.6 per cent appreciation of SGD against USD over the last five years, Asian bonds would still have given a decent return of 18.6 per cent or an annual compounded return of 3.5 per cent in SGD terms versus an annual compounded loss of 0.7 per cent for Asian equities. Furthermore, the risk for Asian bonds is much lower, with Asian bonds posting only one down year in 2008 versus two down years for Asian equities in 2008 and last year.
Asian bonds also offer higher yield compared with other regions. For example, a BBB-rated five-year Asian USD bond currently gives a yield of 4.3 per cent versus 2.7 per cent and 2.8 per cent for a similarly rated US and global bond, respectively.
Asian bonds are also attractive for their relatively lower default rates versus global average. According to Moody's, the default rate for Asian bonds over the last 10 years is only 0.8 per cent versus 1.8 per cent for the global average. In fact, no Asian investment grade bond has defaulted since 1999.
Opportunities for investment
So where are the opportunities amid slowing global growth and low interest rates? Chinese BB-rated high-yield USD industrial bonds (current yield of 9.9 per cent) and the Chinese B-rated high-yield USD property bonds (current yield of 13.2 per cent) look compelling.
At the current yield, we calculate that the market is pricing in a default rate of 20 per cent for Chinese BB-rated high-yield USD industrial bonds and 29 per cent for the Chinese B-rated high-yield USD property bonds over the next five years. This looks excessive given that the historical default rate for Asian high yield bonds is only 4 per cent over the last five years and 3.2 per cent over the last 17 years.
To put things in perspective, the average yield of CCC-rated bonds in the US is 11.4 per cent or an implied default rate of 24 per cent. This means that the market is pricing Chinese high-yield credits as having similar or higher implied default rates than CCC-rated US bonds, which we think is not reasonable.
For local currency bonds, we like the offshore yuan market given that we estimate the yuan is currently still about 20 to 30 per cent under-valued versus the USD. This market has several investment-grade bonds with maturity of only two to three years and giving decent yield of 4 to 5 per cent.
The SGD bond market also looks interesting with several blue chip investment-grade Singapore and Hong Kong developer bonds giving attractive yield of 3.5 to 4.5 per cent for relatively short maturity of three to five years.
As with all investment products, Asian bonds present risks too. The three key factors that affect the returns of Asian bonds are interest rate and foreign exchange risks and the creditworthiness of the corporate issuing the bond.
The first two risks can be hedged away at relatively low cost. For SGD-based investors who do not wish to manage their foreign exchange and interest risks, they can consider buying investment-grade Singapore and Hong Kong property developer SGD bonds with less than five years of maturity remaining.—Today
* Chia Tse Chern is co-head of Asia fixed income at UOB Asset Management. He manages the United Asian Bond Fund, which won The Edge-Lipper Singapore Fund Awards 2012 for Best Fund Over 5 Years in the Asia Pacific Bond category.
* This is the personal opinion of the writer or publication. The Malaysian Insider does not endorse the view unless specified.