Asia's fixed income tide turning: Franklin Templeton

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Fixed income’s emerging market tide is reversing. Institutional investors seeking superior fixed income returns are more likely to find them in corporate credit, including issues from financial institutions, from Europe and the US than in Asia, suggests John Beck, portfolio manager of global fixed income at Franklin Templeton. “Some global banks have been unduly beaten up, and there should be a clearer delineation between stronger and weaker banks,” Beck says.

“Major UK-based banks, for example, are discussing the possibility of partially paying senior executives’ bonuses with coco (convertible contingent) bonds, which means the banks are strengthening their capital buffer. Investors can get yields of 6% to 7% for five- to 10-year euro-denominated credit currently,” he explains.

In Asia, yields are generally lower. Local-currency 10-year government bonds in South Korea yielded 4.81% as of February 9, according to the Asian Development Bank. Indonesian government bonds of the same tenor yielded 8.762% but had already surged 115.6 basis points since the beginning of 2011. According to Markit’s US-dollar-denominated emerging market debt index containing 37 markets, Chinese bonds were yielding 1.62% at the end of December 2010.

Credit default swaps, which indicate investors’ perception of default risk, remain high in major Asian markets, relative to pre-crisis levels. At the end of January 2008, it cost 29 basis points to insure China’s five-year senior bonds, compared with 75 bp in late January, according to Asian Development Bank data. In North America, the cost of insurance in late January 2008 was 331 bp and in Europe, 472 bp. In late September 2010, CDS prices had declined to 234 bp and 356 bp respectively.

Moreover, Asia and other emerging markets’ capital, currency and interest rate controls are shrinking opportunities in what are tiny fixed income markets in the first place. South Korea, one of Asia’s largest issuer of government and corporate bonds, introduced a 14% tax on interest income in January to limit capital flows, for instance.

Indeed, Asian bonds aren’t a panacea for institutions seeking to diversify portfolios traditionally dominated by US Treasuries or domestic government bonds. Guy Stear, head of Asia Pacific research at Societe Generale Corporate and Investment Banking, expects Asian credit markets to remain volatile this year: “It was really the Greek crisis, and not anything Asia specific, which drove the Asia ex-Japan contracts above 170 basis points in the second quarter of last year. Our economists think that the crisis is going to get worse before it gets better and we think this could lead spreads on the index to test at least the 140 bp area sometime in the first quarter of the year.”

But not all emerging markets are alike. Beck of Franklin Templeton thinks institutional investors with long horizons can find fixed income assets with relatively low risk outside of the front-page emerging markets such as Brazil and China. ”

Sovereign ratings are a good benchmark, but the country’s economic health and debt sustainability need to be analysed further. For instance, both Finland and Germany are AAA-rated but Finland has much lower debt. Chile is A-rated and the US is AAA-rated. But Chile, for example, may arguably have better credit quality than the US if you examine its economic fundamentals,” he says.

Government net debt in Chile is estimated to be minus 9.7% of GDP in 2011 and minus 9.3% of GDP in 2015, according to the International Monetary Fund, which is at similar levels as China. On the other hand, the US’ government net debt is expected to be 72.7% of GDP in 2011 and 84.7% in 2015.

Yet, Chile’s US-dollar-denominated sovereign yield was 3.36%, compared with China’s 1.62% as of end December 2010, according to Markit’s emerging market bond index. Ten-year US Treasury yield curve rates were 3.3% and the five-year Treasury yielded 2%.

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