Asia Local Currency Bond Fund - Part 2

Part 2: Interview Article with Florencia & Wai Kiat on the Asia Local Currency Bond Market (September 2017)

We have Ms. Florencia Di Gregorio, the portfolio manager of Asia Local Currency (LCY) Bond Fund, Global Emerging Markets Team at UOB Asset Management in Singapore. After the introduction to LCY bonds in the last article, today Florencia will share about the 3 W's (What, Why, and When) of the Asia LCY Bond Market.

Wai Kiat: Hello Florencia, in the previous interview, you shared basic key information about Asian Local Currency bonds and we are now more familiar with this asset class. For this publication, it'd be interesting to know how a portfolio manager makes investment decisions, focusing on the fundamentals (Why) and valuations (When) of such securities. But first, let's do a recap of what Asian LCY bonds are all about (What). What are we investing in when we invest in Asian LCY bonds and how is it different from investing in an Asian USD denominated bond portfolio?

Florencia: Asia LCY Bonds are fixed income investments where bonds are issued in the local currency of an Asian country such as the Thai Baht for Thailand, Indian Rupee for India, or Indonesian Rupiah for Indonesia, which is different from bonds issued in US dollars.

By investing in this asset class we can look at the returns in two parts – (1) the return on the bonds and (2) the currency returns. Asian LCY bonds offer steady income for investors with yields that are well above those in the developed countries, providing stability to returns. In addition, the currencies will appreciate or depreciate as the countries' fundamentals and relative monetary conditions change in relation to a reference currency (for instance, JPY for Japanese investors).

Wai Kiat: We've been reading about improved fundamentals of Asian countries after the Asian Financial Crisis in 1997. Which metric(s) have improved and how have they changed? Why should we be investing in Asian LCY bonds now?

Florencia: Both bonds and currencies performance are linked to the underlying fundamentals of the countries, which have improved dramatically in the last 20 years. Fixed exchange rate regimes have been liberalised, making the economies more flexible in adjusting to imbalances and shocks. Asian countries have built cushions to make their economies more robust while correcting previous imbalances. Current accounts deficits have been corrected while international reserves have accumulated.

In the Chart 1 below, we see a strong improvement of various metrics to measure adequacy: The total reserves (mainly composed of FX reserves and gold) have increased significantly in ASEAN countries (compared to Asian crisis in 1997) to cover imports as well as the external debt. Current accounts have also improved from a large deficit position in 1997 and back into the black. Putting these metrics together, we see that overall external vulnerability has strengthened significantly over the past two decades.

As you can see in the Chart 2, ASEAN growth has been robust and stable, while inflation has moderated. We believe growth is on an improving trend, while inflation should remain under control.

Wai Kiat: We understand that Asia has stronger macro fundamentals with growth potential but how about the valuations? When is it a good time to invest in Asian LCY bond markets?

Florencia: From a bond valuation perspective, we look at 1) real yields (nominal yield – inflation), which is considered as a "cushion" to protect against adverse external conditions and 2) yield spread with developed markets, as measures of attractiveness.

Let's look at real yield and compare the present to the period before the Taper Tantrum in 2013. The real yields in most of Asian countries before the Taper Tantrum in 2013 (where the change in asset purchases from the US Federal Reserve triggered a sell-off in fixed income and FX markets) were negative or very low. It means that the cushion on valuations was low, not giving much protection to investors against possible adverse change of external conditions.

At present, real yields are positive and higher, making the market less vulnerable and engaging investors to participate in this asset class, as it offers value in the allocation. Flows into Asia LCY markets have been strong this year.

Another way to look at valuation is to look at the yield differential against the developed markets. S&P raised Indonesia's credit rating to investment grade in May 2017, in line with the other two main rating companies (Moody's and Fitch). Now all the Asian countries are at investment grade status, and the credit risk for Asian bonds is lower. Nevertheless, the yield differential has been widening since the 2013 Taper Tantrum and it is substantial now, meaning that the valuations of Asia LCY bonds are cheap.

Wai Kiat: I see. To see if the bond valuation is cheap or expensive, we can look at “real yield” and “yield differential” and the Asia LCY bonds presents attractive valuations from both points of view. How about the currency valuation? When is it a good time to invest in Asian LCY bond markets?

Florencia: From the currency point of view, Asia LCY bonds are attractive. As mentioned earlier, we believe the growth in Asia is poised to move higher as exports are rebounding strongly, while inflation remains muted. This is supportive for FX, while real yields remain attractive vs. developed markets. Valuations for Asian currencies on a trade-weighted and inflation adjusted basis (REER: Real Effective Exchange Rate) are also supportive as they have cheapened since the 2013 Taper Tantrum, offering an attractive entry point as growth is increasing.

To summarise, as the fundamentals have improved, all three conditions favourable for investment into Asia LCY markets are currently present: 1) economic growth is expected to be higher, 2) valuations are cheaper, 3) while external conditions (such as accommodative monetary policies of developed countries, capital flows searching for yields, relatively calm investment environment aside from the geopolitical concerns, etc. appear supportive.

When we are confronted with the decision of investing in an asset class that performs well during economic recoveries, Asian LCY bonds are in a sweet spot with attractive valuations, low inflation and better growth expectations, while monetary conditions in developed markets remain supportive for the search of yield.

Asian LCY also offers lower volatility plus a steady income compared to equities, which also perform well during phases of synchronised growth improvement similar to what we're seeing now.

Wai Kiat: Thank you for the very detailed explanation Florencia. With the global hunt for yield stretching valuations in most parts of the world, it's really useful for investors to know that valuations in LCY bonds are still appealing, especially when we measure this on a risk-return adjusted basis. Strong and much-improved fundamentals of Asian countries will assuage fears of a recurrence of the Asian Financial Crisis. With these factors taken into account, the attractiveness of Asia LCY bonds should not be ignored.

For our next and last interview, we would like to ask you about your outlook and strategy for this asset class, as well as the general trend or demand from Asian investors for Asian fixed income in general. Thank you once again for your time.