International investors are reassessing the merits of traditional fixed income benchmarks and some are moving towards a less constrained investment style or looking to invest on a GDP-weighted basis. This could cause problems as Asian bond markets remain relatively underdeveloped.
The Asia weight in the Citi World Government Bond Index (WGBI) – one of the most frequently referenced global benchmarks – is less than 1%. On a market-cap basis, the figure would be more like 8%, but WGBI is both market-cap and rule-based. The index excludes China, India and South Korea, the three largest countries in Asia ex-Japan.
Because of the exclusion of large Asian markets from global benchmarks, international investors have had to launch Asia-specific strategies if they want to gain exposure to the region.
“[At the moment] global investors will systematically underweight Asia on a market-cap based methodology. That’s bizarre because if you think about it, why would an index underweight,” said Rajeev De Mello, head of Asian fixed income at Schroders to Asiamoney PLUS.
“A global mandate is not going to give you [Asian exposure] and an emerging market mandate is still giving you less than 20% exposure to Asia. If you actually want to invest into the heart of the emerging market – which is Asia – you have to have a specific mandate,” said Endre Pedersen, managing director, fixed income at Manulife Asset Management.
As a result investors are taking another look at the composition of global indices. An alternative to market-cap investment is a GDP-weighted bond index, which allocates bonds and currencies accordingly. In a GDP-weighted index, the US would remain large in terms of overall weighting. Japan would shrink and Asian countries – particularly China and India – would increase relative to Japan.
For example, in December last year Pimco introduced its GDP-weighted Global Advantage Bond Index (GLADI). The US weight is 23.50%, the Eurozone is 20.80% and Japan is 8.30%. However, China only comprises 1.24% of the index and India accounts for 1.20%.
This is because eligible bonds must be investment grade, fixed-rate, non-callable bonds with at least 12 months remaining with a minimum size of US$500 million for emerging market external corporate bonds and an equivalent of US$100 million for local currency debt. As such, the index is not a pure GDP-weighted benchmark.
“There are problems with [a pure GDP-weighted] approach, as it would give you the percentage for each country without telling you the duration of the market and which maturities are in your benchmark. So then an investor has to turn to some other anchor point and say: that country’s duration is long and you have more of it. So then it might be better to look at a benchmark within each country, and you fall back into problems,” said De Mello.
There are advantages to rules in global benchmarks such as Citi’s as they include factors such as accessibility of the market.
“If you have a large allocation to China in a GDP-weighted benchmark but you can’t invest in the domestic market because QFII [Qualified Foreign Institutional Investor] quotas aren’t large enough, that poses a challenge especially for countries where the debt-to-GDP is very low, because you might not have enough bonds, or bonds will be very expensive,” said De Mello.
Another problem with a GDP-weighted index is that they may not take into account the quality of the bonds themselves.
“The underlying pool of securities may not actually be able to justify such large weights. And that’s a situation whereby conceptually it’s an interesting idea but to replicate that within what is still a relatively small China/India component of global markets, becomes very difficult,” said Bryan Collins, fixed income fund manager at Fidelity Worldwide Investment.
Distortions
As more money flows into Asia and emerging markets, there is an increased possibility that supply and demand imbalances could cause distortions in valuations and push them further beyond the underlying fundamentals, said Collins.
“To the credit of institutional investors, they are cognisant and appreciative of market limitations. So you will often find benchmarks that exclude China and India because you can’t access the market,” said Collins.
However, as the Chinese onshore debt market develops and the QFII and capital account opens up, investors will strategically allocate more to China which will spur further market growth.
“So China’s potential to grow and represent a large investment pool is going to be met fairly quickly and the supply will be able to match the demand. Places like the Philippines, Indonesia and India are a little bit harder,” said Collins.
“While their GDP-growth is quite high, the nature of the markets and how they are structured does provide some limitations. But as they see China open up and develop its debt capital market, they will see the benefits that that can bring.” An increased global allocation to Asia could also have a positive impact on the development of Asian bond markets.
“Sometimes it’s a chicken and egg situation, but having a benchmark can lead to the good development of a market in terms of standards of care and attracting issuers to issue in scale, size and with ratings,” said Sabita Prakash, head of Asian fixed income investment at Fidelity.
Many global indices will not include bonds worth less than US$300 million, so a corporate issuer in the emerging market space would be likely to think twice before issuing a smaller sized bond, if there was a possibility it might be included in the index.
“It gets the company greater exposure to global investors and they in turn improve their transparency, disclosure, and they learn more about the international debt capital markets and institutional investors, so it can be a very powerful positive development,” said Collins.