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Asia Local Currency Bond Fund - Part 3

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Part 3: Interview Article with Florencia & Wai Kiat on an Asia Local Currency Bond Market (December 2017)

Ms. Florencia Di Gregorio (left), VP, Emerging Markets Fixed income
with Mr Soh Wai Kiat (right), Fixed Income Analyst

In the first two articles we talked about the characteristics of Asia Local Currency markets, the economic fundamentals of Asian countries which have improved significantly since the Asian Financial Crisis and the attractiveness of this asset class from a valuation perspective.

In this discussion we would like to discuss more about the outlook and strategy regarding Asia Local Currency bonds and currencies.

 

Wai Kiat:  Investors choose different asset classes (mainly between equities and fixed income) depending on their risk profile or appetite. How does the position of Asia Local Currency bond itself fare within the fixed income universe, and how does it compare to equities in terms of risk profile?

Florencia: We can say that an Asia Local Currency bond investment is midway between a developed market’s bond investment and an equity investment in terms of risk profile and performance. High grade bonds are considered a safer investment compared to equities, as investors are more prone to have capital gains and losses in their investments for the latter.

During global expansions, Asia Local Currency bonds tend to perform better than bonds in the developed market, while equities outperform both asset classes. During crisis, Asia Local Currency bonds have a better performance than equities, while developed market's bonds are the lowest performer due to its better capital conservation features. This is why Asia Local Currency bonds are in between fixed income bonds and equities.

Note:
– Asia Local Currency: JP Morgan JADE Global – Asia Diversified Bond Index
– DM bonds (G10 Developed Markets Bonds): JP Morgan GBI Global Index
– Average Equities G3: Average of S&P 500, Euro Stoxx 50 and Nikkei 225
– Performance expressed in JPY terms
Source: UOBAM, Bloomberg, JP Morgan Index (data as of 14th Dec 2017)

 

Asia Local Currency is a fixed income investment dominated by sovereign bonds in the currency of the issuing country, providing steady returns to investors through the interest return.

When investing in Asia Local Currency, investors will experience the currency fluctuations from the underlying local bonds, which can also produce capital gains or losses in their investments. Currency and equity returns are related, as both asset classes are linked to growth in a particular economy. As such, better economic growth usually translates into a rise in currencies and equities valuations for a particular country.

Asia Local Currency bonds perform well and currencies tend to appreciate when growth is improving. In the early stages of economic pick-up, inflation tends to be subdued and Local Currency bonds will remain relatively stable. As the economic cycle matures and inflationary pressures start to build up, bond valuations soften as rates increase.

We expect global growth to increase, with growth in emerging markets increasing more than growth in developed markets, which should support Local Currency markets.

Note: From 2017 onward, the figures are the forecast
Source: UOBAM, IMF – World Economic Outlook (data as of Oct 2017)

 

This is relevant when we want to decide when to invest in bonds or in equities, as it is related to the growth cycle of a certain economy. During economic downturns, investors prefer safer assets and tend to buy more high quality bonds, while during economic booms, investors' risk appetites increase and as a result they allocate more to risky assets such as equities.

Local Currency investments are in the transition from safe high grade bonds into equities as economic performance improves: they are less risky than equities, while providing a risk seeking profile in the fixed income universe.

 

Wai Kiat: That's interesting. So, how do you see growth prospects in 2018 and how do you think it will impact Asia Local Currency bond investments?

Florencia: Global growth is improving since late 2016 and it is synchronized across regions. Exports in Asia have improved and growth expectations are increasing. While Asian currencies should remain sustained by this improvement in global economic performance, local rates are likely to trend up but less so than in the developed markets, and as inflation remains contained in Asia, it means that Asian Local Currency bonds are expected to outperform bonds in developed markets.

 

Wai Kiat: That's great news for Asia Local Currency bond investors. However, beyond healthy economic growth, what are the positive and negative drivers of performance for Asian Local Currency bonds?

Florencia: On the upside, the performance will be positively impacted by a better than expected regional growth in Asia that would support currency appreciation, while enjoying a stable external environment.

As for the downside risk, we believe that it can arise from higher inflation or much stronger equity prices in developed economies that could steepen the pace of rate hikes in the G3 countries (US, Japan and the Eurozone). A deeper than expected slowdown in China could also have an adverse impact on the region.

As a base scenario, we believe the gradual removal of accommodation from the G3 countries exiting from their unprecedented monetary stimulus could bring some instability to fixed income globally. But in the current context where Asian economies are in a better position to navigate the market volatility, we believe that Asia Local Currency bonds could offer interesting investment opportunities in 2018. As for China, considering that the government has committed to focus on structural reforms (which are well pursued so far) and the profitability and debt profile of China corporates have been improving, we have a more positive outlook for China, giving more comfort in local bond investment.

 

Wai Kiat: To summarise, Asia Local Currency bonds will suit investors looking for higher returns on top of the stability that high-grade bonds can provide. With Asia's continued economic growth and gradual removal of monetary accommodation from the G3 central banks, downside risks look limited and should provide comfort to investors.

We have also seen increasing demand for this asset class, especially from Asian domestic investors who feel more comfortable investing in Asian names in Asian local currencies, with the number of portfolios that have exposure to this asset class increasing.

We hope more domestic and international investors discover the attractiveness of this asset class.

Many thanks to Florencia for your insights.

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