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Credit in favour as rates are set to turn

30 Jan 2004

Roundtable Participants
Bas Van BuurenSenior investment manager, fixed income, ING Investment Management, Asia PacificAsian bonds under management: $230mBenchmarks used: JP Morgan Asia Credit Index (JACI) and JP Morgan EMBI Global Asia
Wee Peng LianInvestment manager, Asian fixed income, Aberdeen Asset Management AsiaAsian bonds under management: $1bnBenchmarks used: ML Asian dollar indices, HSBC Local Bond Indices
Aaron LowVice president, portfolio manager, PimcoAsian bonds under management: $1bnBenchmarks used: JP Morgan, Global EMBI+, Lehman Global Aggregate, Salomon Brothers World Government Bond Index
Kon Chee KeatAssociate director, UOB Asset ManagementAsian bonds under management: S$3bn excluding CBOs, S$12bn including CBOsBenchmark used: Mainly the JACI
Adeline NgPortfolio manager, ABN Amro Asset ManagementAsian bonds under management: S$900mBenchmark used: HSBC Asia Dollar Bond Index (ADBI)
Ben YuenHead of fixed income, First State Investment ManagementAsian bonds under management: $375mBenchmarks used: JACI and HSBC ADBI

For investors in Asia's bond markets, 2003 was a year to savour. Active managers achieved total returns reaching into double digits.   The environment is likely to be tougher in 2004. Economic growth should remain strong, but may be offset by interest rate rises. Richard Morrow discussed tactics with six Asian bond fund managers.

What was your strategy to outperform your Asian benchmark during 2003?
Bas Van Buuren, ING:
We have generally been overweight risk in our regional portfolios. This means we have been overweight in high yield corporate names from Indonesia, the Philippines, Korea and Thailand.

Conversely, we have been underweight on China, Korea and Thailand. The strategy has meant that our flagship fund has outperformed the benchmark by 2.3%.

Aaron Low, Pimco: It has been really a benchmark story. We have underweighted Asian bonds against the EMBI universe due to their tighter valuations.

The only liquid and cheap sovereigns have been the Philippines and Indonesia, and there are some high yield corporates but the asset class is shrinking in terms of spread offerings that were attractive to us.

Adeline Ng, ABN Amro: During 2003 we added value through our duration call, country allocation and issuer selections. Of these three dimensions of risk, country selection contributed the most.

We took defensive positions in high grade countries such as China and Singapore during the period of Iraq tension and then moved down the credit spectrum into high yielding countries and high beta credits after the tensions had ended, to position for rising investors' appetite.

This strategy contributed positively to the funds' performance.

Ben Yuen, First State: We used three approaches in 2003. First we were overweight on a few countries, such as Malaysia.

Second, we used spot selection to look at particular credits we felt would outperform, such as Philippine Long Distance Telephone (PLDT), and third we combined the two approaches, such as buying Petronas bonds in Malaysia or buying Thai banks' subordinated debt.

As a result of this strategy, we have had quite good returns over the year. Bangkok Bank's bonds have a year to date total return of 18%, PLDT's bonds returned 27% and Petronas's 2026 issue returned 18%. Overall we have done better than our indices, with our credit fund (which includes corporate bonds) outperforming the ADBI by 3.7%.

What were some of your best performing credits, and did any surprise you?
Wee Peng Lian, Aberdeen:
We found that bonds from Thailand, Singaporean and South Korean subordinated debt, together with Malaysian sovereign and quasi-sovereign issues, stood out for us.

Most of the outperformance during the first half of the year was on the back of the rally in US Treasuries. Thereafter, credit spreads tightened in response to rating upgrades and positive fundamental news.

As an example, the long dated Bangkok Bank 2029 bond rallied from around 101.00 in price terms at the start of the year, to over 110.00 recently.

Low, Pimco: Hutchison bonds, Korean bank subordinated debt and Petronas were the best performers for us.

We also took advantage of the lows during the SK Corp crisis to buy into Korea sovereigns after the central bank stepped in to provide support, which was also a good tactical trade.

Indonesia was a positive surprise, performing better than expected and engaging a relatively more prudent policy.

Unfortunately, liquidity is poor, which does not allow us to be more constructive.

Kon Chee Keat, UOB: We have had a good run from Indonesian credits, including Freeport, which recorded more than 20% in total return.

Other top performers include the bonds of PLDT, CeCasenan, PCCW-HKT, SK Corp and Shinhan, which recorded total returns of 25%, 15% and 14% (year to date) and 5% and 4% (over three months), respectively.

Market sentiment towards JG Summit group is surprisingly negative, resulting in the bonds underperforming the sovereign and corporate bonds significantly, regardless of the direction of the market.

Ng, ABN: Our best performing sectors were bank subordinated debt and telecoms deals.

The performance of the Philippines sovereign was impressive for a credit that went through phases of fiscal concerns, risk aversion during the Iraq tensions, refunding pressures, military mutiny and political noises.

With a year to date return of around 10%, the performance is remarkable.

Van Buuren, ING: Our best bet has been on Indonesia, especially in the portfolios where we could buy Indonesian standby loans.

Those have returned over 90% this year.

Did the sovereign rating upgrades in Asia during 2003 affect your investment strategy?
Ng, ABN:
The upgrades led us to lock in some gains and pare down some of our overweight bets but this has not changed our original investment strategy and preference for our overweight countries.

We expect more positive rating actions in Asia this year on the back of good economic growth prospects, improving external balances and fiscal discipline.

The potential candidates for positive rating actions include China, Thailand, Indonesia and South Korea.

Yuen, First State: The likelihood of sovereign rating improvements was an important market factor during 2003.

Both Malaysia and Korea's spreads tightened, while many corporates were upgraded as they had previously been capped at the sovereign rating ceilings, and also enjoyed spread performance.

Van Buuren, ING: It affected our strategy to a limited extent, in that many of the upgrades were much anticipated and priced into the market, with the exception of Malaysia.

Given our core underweights in China, Hong Kong and Thailand, the rating upgrades did not impact the relative performance.

Our overweight position in Malaysian and Indonesian bonds paid off.

Kon, UOB: We made no major strategy changes after the upgrades but rather the anticipation of rating actions for Indonesia resulted in us increasing our weighting.

Most Asian bonds have narrowed to very tight spreads over the past two years. Is there any more scope for spread performance in 2004?
Kon, UOB:
Philippines sovereign and corporate bonds are trading at single-B levels and thus have the highest potential for spread tightening when the political scene becomes less murky.

We think that selective credits in various countries have spread tightening potential too.

Yuen, First State: We are unlikely to see the double digit absolute returns in 2004 that the previous three years enjoyed. I would expect the year will result in total returns of 5%-6%.

Even though high grade bonds have been relatively tight over the past three years, if the economies in the region keep growing then their spreads could grind in tighter still. High grade issues could gain another 20bp of performance in 2004.

High yield performance will depend on selecting the right names at the right times, but if you buy and sell at the correct points then it could be possible to get a very good performance.

Active management is key to this and if done correctly it could result in double digit returns.

Van Buuren, ING: Some spread performance remains, as external creditworthiness in Asia is still improving and the upward rating cycle is not over yet.

It is important to notice that on a bond index level, Asian credit spreads are at the same level as US corporate spreads. So in that context, we do not agree with the assessment of some that Asia is too tight. Perhaps it is tight historically ? but it is not too tight.

Countries that can see further spread tightening are Korea, Malaysia, Indonesia, Singapore, Pakistan and ? possibly ? the Philippines. Some Hong Kong telecoms and corporate names can still trade tighter, as can Korean banks.

Wee, Aberdeen: There are still some laggards in specific credits, particularly in bank subordinated debt issues in specific countries.

Low, Pimco: Obviously, the upside performance is unlikely to be as strong as it was in the past year, but then isn't that happening to most bonds?

The movement has been more towards corporate paper ? especially the large, liquid ones ? and further down the credit curve, though I do not think investors are getting more duration exposure.

The next move will have to depend on further upgrades and the markets have already priced some of those in, so again limiting further upside. Also, the improving equity story has carved out some of the retail support that bonds have enjoyed.

Spread performance is likely to remain in 2004, given the expected recovery in markets and election year premiums, but some credits should become a little bumpy precisely because of this.

What is your company view on US interest rate movements in 2004? If rates rise, what will be your strategy to outperform the bond market?
Yuen, First State: Our view is that rates will remain unchanged for the first half of the year. The US employment figures need to improve before we are likely to see a US economic recovery and US corporates have been gradually deleveraging anyway.

As a result, rate movements are unlikely until the second half of 2004 and the 10 year Treasury will remain range-bound.

Asian bonds have seen quite high absolute returns due to spread tightening and US Treasuries tightening too, but there is no room left for capital gains from the US bond market in the coming year.

In this scenario high yield paper in Asia seems to be the best way to benefit from any possible tightening or volatility.

Van Buuren, ING: Our house view is that the Fed will only hike rates in the second half of 2004, but that the long end of the curve will start to move higher sooner, probably in the first quarter. To outperform, you need to be short duration, which we are.

Kon, UOB: Our 10 year US interest rate estimate for 2004 is 5%.

To mitigate the negative impact of rising US Treasury yields, we are seeking credits that have improving credit fundamentals, and could therefore offer better spread performance than the rest of the market.

Ng, ABN: The market is pricing in some gradual monetary tightening over 2004.

Fed officials, however, have continued to argue that inflation risks remain skewed on the downside and that monetary policy will remain accommodative for an extended period of time.

We believe the Fed's credibility would be seriously damaged if it were to start tightening rates in the next few months.

Our base case scenario calls for economic growth to gradually fall back in 2004 as the impact of policy support fades and economic imbalances (such as twin deficits, balance sheet vulnerabilities and consumers' financial positions) unwind.

While some modest tightening can still be justified in this scenario, the process will start later and be of lesser magnitude than the market is assuming.

In the event of a rising interest rate environment, long duration and low yielding bonds would suffer the most, meaning that high grade Asian bonds would be the most vulnerable.

Short duration and high yielding bonds enjoy the cushion of low interest rate sensitivity and high coupons, so this may favour the lower credit quality Asian high yield segment, on a credit specific basis.

"ABFs should be actively managed"

Eleven Asia Pacific central banks have put $1bn into an Asian Bond Fund, managed by the Bank for International Settlements. The fund buys public sector dollar, euro and yen bonds ? but now the central banks want to set up a second fund to buy local currency and private sector bonds. EuroWeek's investor panel discussed with Richard Morrow whether the funds will promote Asian markets, as intended, or could actually impair liquidity.
The 11 ABF investing countries
Australia, China, Hong Kong, Indonesia, Japan, Korea, Malaysia, New Zealand, The Philippines, Singapore, Thailand
Are the Asian Bond Fund and ABF II good market developments? What needs to be done to maximise their positive impact?

Wee, Aberdeen: The ABFs will provide support to the bond markets and encourage more Asian corporates to consider raising funds via debt, instead of traditional bank loans or equity. It may mean that more non-Asian potential issuers begin looking at issuing in the domestic markets.

For corporate issues, some form of credit rating system should be established to provide a consistent rating for companies across the region.

Low, Pimco: The ABFs are a positive market development and it was surprising that a regional agreement to do them was built in a relatively short period of time.

But while they are a positive market development, they may not necessarily be a positive investment development.

The ABFs need to help develop the asset class in terms of liquidity and price discovery by being actively rather than passively managed, while the benchmarks should be more transparent to the investment community.

We need to raise the attractiveness of a regional benchmark. Asia is becoming more integrated in terms of its economic structure and exchange rate policy, so it makes sense to consolidate more activity into a regional index or benchmark that reflects the region's economic fundamentals.

Most individual countries are too small and illiquid to form a realistic asset class but the regional benchmark offers a rich variety of rating diversity ? and lately, maturity diversity as well ? and has a much better chance of success.

The aim of an active approach is to improve price-making mechanisms and so provide better investor confidence. If the funds are passively managed, liquidity in Asian bonds might be reduced even further, which would be damaging to the asset class.

The region's credibility would be further increased if we moved away from the notion that the fund would be a natural insurance provider for regional issuers.

Yuen, First State: It was a good move by the central banks to put money in the ABF as it encouraged investors from outside the region to invest in Asia's bond markets.

But $1bn really is peanuts when set against the amount of foreign currency reserves that the central banks possess. The banks should commit more resources, while broadening the names the fund can invest in to investment grade bonds as well as sovereign and quasi-sovereign deals.

The ABF may also need a change in management. The BIS is managing the fund passively. By replacing them with an external fund management company and increasing the fund size and breadth of investment, the ABF could promote market liquidity.

30 Jan 2004