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IPE special report May 2018

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Asian debt takes centre stage

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Asian debt provides diversification and good risk-adjusted returns, argue emerging markets managers. Maha Khan Phillips takes a look at how institutional investors can access the asset class and where the best opportunities lie

In December, all eyes turned to Copenhagen as the largest ever summit on climate change collapsed into discord. As the finger pointing and recriminations began, one thing became apparent. The world's economic power players have well and truly changed. When a tepid deal was finally brokered, it was brokered by the US with the ‘BASICs' - India, China, Brazil and South Africa. Europe wasn't even invited to the table.

Emerging markets managers argue that events at the summit support what they have been saying all along. While Europe and the US still reel from recession, emerging markets have fared far better, developing economic muscle and posting much stronger growth figures. They will dominate in the future. Institutional investors have bought into this argument, increasing allocations. But they have yet to be convinced about Asian debt, which, say managers, is fundamentally undervalued and a very attractive proposition.

"You cannot ignore a region that is going to be leading the world in growth in the next three to five years," argues Anthony Michael, head of fixed income, Asia for Aberdeen Asset Management. "Institutional investors have to think about how they will manage their strategic allocations to Asian fixed income."

Joel Kim, head of Asian debt at ING Investment Management, points out that returns from both local and hard-currency debt have been equivalent to those from equities in Asia this year, with less than one-third of the volatility.

Macro
Asian debt also offers strong diversification, both from other bonds and between countries in the region. Credit ratings range from AAA in Singapore to B in Pakistan, and markets vary in sophistication and size. "You are looking at yields ranging from 1% to 10%, in the case of Indonesia," explains Michael. "So you immediately can understand that there is a diversification argument within Asia itself."

Adeline Ng, head of fixed income at Fortis, believes that many investors make assumptions about the emerging world that simply aren't true. "Volatility over the last 10 years has been approximately 6.5%, only a touch higher than US Treasuries at 5.5% and US high-grade at 6.4%," she says. Over the same period, Asian hard-currency bonds returned 8.7% and local currency-bonds returned 8.3%, compared with global government bonds, which generated 7.9%. US Treasuries returned 5.7%, US high grade produced 6.5%, US high yield returned 7.6% and global emerging markets returned 10.2%. "Asian bonds, both dollar and local currency, offer good Sharpe ratios," adds Ng.

She also stresses that Asia looks attractive from a fundamental point of view. The majority of countries in the region have low debt-to-GDP ratios, ranging from 30-50%. Japan, the euro-zone, and the US labour under ratios closer to 80-90%.

Asia has also been largely buffered from the sub-prime crisis. "Asia has not seen the high yield crisis that we have had in other parts of the world, and most countries in Asia have been able to navigate the global recession very well," says Claudia Calich, head of emerging markets in the fixed income division of Invesco. "There are very few systematic or banking problems. The credit channel is also not broken, unlike the Baltics, where they are having a very serious banking crisis."

The credit crisis, which resulted in a ballooning of G7 governments' debt and expansion of their monetary bases, will most likely lead to the accelerated appreciation of several Asian currencies, argues Peter Marber, global head of GEM fixed income and currencies at Halbis Capital Management. "With an estimated 5-6% expansion rate, we believe developing Asian economies have led and will continue to lead global growth in 2010, while US and European countries might only advance between 1% and 2%, depending on the countries," he says.

Indeed, Jerome Booth, head of emerging markets at Ashmore Investment Management, believes that, because it provides an effective hedge against the risks in developed economies, the best place to access the market is at the short end of the local currency curve. "In the worst case of global depression and dollar collapse, local currency is the best hedge there is," he says. "That's why institutional investors are using it as an insurance policy. If you are worried about the US dollar, then the short duration local currency debt market is the safest asset to be in."

Access
Investors can access the market in several ways - through investment in sovereign and corporate debt, through local or hard-currency. Local currency debt finance was developed after the 1998 Asian crisis - a wake-up call for governments across the region not to rely exclusively on foreign currency. With diversity of size and policy, Asia has a unique opportunity-set in currency and interest rate exposure, argues Michael.

Managers also say that Asian bonds, especially corporate credits, are undervalued. "Why should bonds from Asian issuers with A or AA ratings trade at much cheaper levels than similarly rated credits from the US or Europe, especially if you look at the macro environment going forward?" asks Kim. "Over the past few years, the number of fallen angels has been minimal. As a percentage of the total Asian investment grade debt universe that we cover, it has been low single digits. That compares very well with, for example, the US, where that number has been much higher." If credit spreads are supposed to compensate you for default risk, that risk in Asia is much lower than what is currently priced in."

"In terms of its credit spread, current valuation is too cheap," Ng agrees. "If you look at average investment grade spread, it is pricing in 10-15% default probability over five years, but global default rates over the last 10 years were in single digits."

Dorian Carrell, product manager for convertibles at Schroders, believes that ratings are too low, simply because of a lack of available credit history and lack of coverage by the rating agencies of Asia. "The level of Asian fixed income research on the sell-side was never as compelling as on the equity side, and last year this diminished spectacularly," he observes.

Not everyone agrees. Peter Eerdmans, head of the emerging markets debt team at Investec, warns: "If you look at dollar debt and credit, we don't see a lot of reason to invest in Asia. We much prefer other regions where spreads are more attractive."
Booth adds: "You have to have liquid functioning sovereign yield curves before [a corporate bond] market can really start, and that will take some years. Until that happens, governments will have to issue in dollars, because there is no liquid curve yet. Corporate debt is all about the dollar issuance off those sovereign curves."

Schroders believes that investors should be accessing convertibles. Kurt Fisch, head of convertibles in Asia, says that convertibles offer strong diversification by countries and sectors. China, Hong Kong, India, Singapore, Malaysia, Taiwan, and Korea are all important markets, and sectors range from big industrials to consumer discretionary and consumer stables. The firm points out that convertibles act as an inflation or deflation hedge, and that in the last major inflationary period they outperformed government bonds and equities. Their combination of short duration bond and long-dated option might be the ideal combination to hold in the current environment where healthy long-term fundamentals run up against shorter-term market uncertainty.

Limitations
Nonetheless, investors who want to invest in Asian debt are hampered by benchmark limitations. As Michael points out, the traditional approach to investing via global benchmarks means that Asian is poorly represented. The Barclays Global Aggregate Bond index allocates just 2% to Asia ex-Japan, while the JPMorgan EMBIGD includes only US dollar-denominated bonds and, within this, Asian sovereign and corporate issuers comprise just 20%. "They are massively under-represented in standard benchmarks," he says. He advocates an active approach for adding alpha. He also believes that currency overlay could be an option for investors looking to hedge back to a specific currency, or as a source of pure alpha.

Investors must also consider whether they invest directly or through a broader emerging markets portfolio. Managers argue that a broader portfolio provides flexibility. "The question for pension funds is: ‘Do I split Asia out and run an overweight through a dedicated Asia fund, or do I have an emerging market debt fund and let my manager decide where the opportunities are?'" says Peter Eerdmans, head of the emerging markets debt team at Investec. "I think most funds would be better off letting a manager decide that."

The majority of managers believe that any approach to the asset class should be strategic, rather than tactical. They point out that the market is attractive now, but will continue to be so in the future, and should be considered a long-term play for diversification and risk benefits. "We very much see Asia as a long-term, strategic part of the portfolio," says Schroders' Fisch.

Others say a tactical approach will bring performance gains. "Our flexibility to be able to allocate tactically to Asia is very important," says Insight Investment's head of emerging market bonds Colm McDonagh. "There are times when Asia needs to be a big part of the portfolio, and others where it needs to be reduced quickly. We need the flexibility to manage that."

There is one thing that managers agree on, however, and that is the significant potential in the market - providing institutional investors can be convinced of its merits.
 

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