Adrian Zuercher, head of emerging markets. strategy, CIO Office, Credit Suisse Asset Management
In general, we want to be long risk during 2013. With the quality or risk trade having gone on for so long and having become so extreme, the relative pricing of safety and risk have also become extreme. Risk attributes have become cheap and safety attributes very expensive. As central bankers have increasingly eliminated the major tail risks around the globe, we think that the valuation gap between safe haven investment such as core market government bonds and risky assets starts to weigh heavily.
To conclude, we expect a structural shift will take place along the risk curve away from core government bonds into riskier assets, equities in particular. However, in light of the ultra-low yields in the core-market government bond space, Asian bonds are still an interesting investment, especially when considering the underlying macro fundamentals. The structural improvement in credit worthiness over the last years has considerably reduced volatility in these bonds.
We, therefore, expect that flows within the fixed income space will be further geared to Asian bonds as they offer higher yields than Westerner peers and are a reasonable close substitute in terms of risk and volatility. Demand should also stay high because we think that the sovereign rating gap between Asian countries and developed markets will continue to narrow in 2013. We believe that demand will in particular stay high for local currency instruments in Asia. We expect currency movements and carry to replace duration as the key driver of local debt performance because Asian yields overall are down to their lowest since 2003.
Frances Cheung, senior strategist Asia ex-Japan, global markets research, Crédit Agricole
As risk appetite gradually returns, there could potentially be some asset re-allocation from safe assets to riskier assets, and by broad asset classes it means from bonds to equities. However, we think this “great rotation” has not become a common trend yet. Instead, within emerging market bonds, a re-allocation from hard currency bonds to local currency bonds is in the making.
Emerging market dollar bond spreads have come in a lot in the past one and a half years. Although there could still be some room for narrower spreads, given that we expect an obvious upward move in US Treasury yields, emerging market dollar bonds yields will rise. We do expect local currency bond yields to go up too.
That said, for those funds which primarily invest in fixed income products, including foreign exchange reserve portfolios, they would still need to pick relative values. One theme that we have been highlighting for more than a year is the diversification from low-yielding developed market sovereigns to selected Asian sovereigns, which may well continue.
Added to this will be the shift from dollar bonds to local currency bonds for various Asian names. Asian sovereigns will benefit further. We continue to observe that Korea treasury bonds and Chinese government bonds are attracting foreign interest, while we remain cautious against India government securities given the country’s twin deficits, and even more so after the latest budget.
Looking at the performances of local currency equities versus bonds, while bonds had outperformed we consider that the ‘bubble’ as not too big regarding Asian sovereigns compared with the situation regarding US Treasuries.
However, investors should not look for capital gains, but for the coupon pick-up vis-à-vis developed market bonds, and the exposures to Asian foreign exchange when they invest in Asian bonds. As such, investors may prefer to go for shorter duration.
Andre de Silva, head of Asia Pacific rates, HSBC Global Research
There is little evidence that the Asia bond market is currently subject to a great rotation into equities. Inflows into the local currency bond market have been relentless, especially in emerging markets.
Even during the recent period of volatility and temporary periods when risk appetite moderated, inflows into emerging market local currency debt continued, which was not the case for equities or, to a lesser degree, for emerging markets hard currency debt.
To put things into a broader context, according to data from EPFR Global year-to-date emerging market local currency bond flows have reached a staggering US$8.7 billion, which is 76% of the full year inflows into local bonds in 2012.
Therefore the strong performance of several equity markets in Asia has not been at the expense of local currency bonds. There have also been other supportive factors, in particular for two of the most favoured Asian local markets previously identified by HSBC Fixed Income Research as key to portfolio returns for the first half of 2013 – the Philippines and India.
In India, the continuation of fiscal reforms via the budget is likely to see aggressive bidding for foreign institutional investor licences on February 20 translate into a sizeable proportion of foreign buying of government bonds. For the Philippines, although a prospective upgrade to investment grade status is well anticipated further inflows are likely, just as happened in Indonesia.
More generally, currency considerations are also key. The depreciation of major currencies through quantitative easing remains firmly intact, in turn placing pressure for emerging market currencies to appreciate. Also, a more established local currency government bond market in Asia and high correlation with US Treasuries does not necessarily imply foreign outflows during bouts of heightened risk aversion, as may be the case for equities.
Even during recent periods of isolated Asia foreign exchange volatility – for example, Indonesia and Malaysia – the government bond markets have been remarkably stable, in line with entrenched high foreign ownership. For example, in February there were US$600 million net inflows into Indonesian government bonds.