Re-working Asian bond portfolios
With a dialing down of risk and sensitivity regarding credit quality, bond portfolios have had to be re-evaluated. Joseph Mariathasan finds out what this means for Asia.
The developed world financial markets were at the epicentre of the global financial crash, and the world is still living with the ramifications of a profound shift in the structure and credit quality of global fixed income markets. But as Brian Baker, CEO of Pimco Asia explains, the financial crash itself had little direct effect on Asian institutions. The central banks, insurance companies etc had little exposure to the US housing market through sub-prime securitised debt, unlike institutional investors in Europe. However, at the height of the crisis, central banks and other investors tried to understand the financial crisis in the developed markets, and its effects on all assets on their balance sheets, after the years of progressive risk taking in 2006 and 2007.
Asian investors have been and still are major investors in US treasuries. One of the most striking examples of the seismic shift in global fixed income markets is the recent announcement by Standard & Poor’s that it has changed the outlook for the AAA rated US treasury bonds, the ultimate risk free asset, from stable to negative. This implies that it may lower the US sovereign debt rating over the next six months to two years.
Despite any concerns over credit quality, there has not been any significant selling of US treasuries by Asian institutions according to Neeraj Seth, Head of Asian Credit for BlackRock. What has been happening though, is that many central banks in the region are looking at ways of diversifying their exposure, for a number of reasons: “Reserves have been going up and when this is combined with quantitative easing, there is more money to put to work. The incremental money is there and institutions are looking at other assets such as emerging market investment grade local currency portfolios” says Seth.
What they are less keen on is taking on European credit risk by investing in Euro denominated government debt: “Central banks are very concerned about the credit risk of the peripherals and are not jumping into them. The Chinese policy makers made statements saying they would support peripheral country debt issuance in the Eurozone, but there is no evidence of them doing that in size and the spreads are widening” says Baker.
Whilst there is increasing interest in emerging market local currency debt, this market is not large in Asia: “The biggest debt market with open access in Asia is Korea. Central banks have a slightly different opportunity set to other investors as some of the CBs are allowed to have exposure to the Chinese on-shore bond market which fund managers cannot access” says Seth. China is gradually opening up its bond market: “A few quarters ago, as the first step for free currency convertibility, China introduced swap lines and a quota for central banks and sovereign wealth funds to access the local onshore bond market based on trade.” Apart from Korea, other significant Asian debt markets would be the Malaysia, HK, Singapore, Indonesia, Philippines, and Thailand. India, like China, is a large restricted market and it has a quota system.
Another asset class that has attracted some interest is global inflation-linked bonds: “In Asia, there is not a lot of product, only Korea and Australia issue inflation linked bonds, so investors go for a mix of global, US and Australia, which is seen as a proxy for the US. A lot has to do with liquidity in the markets. If you are indifferent between products, US products stand out because of their liquidity.”
Where there has been some debate amongst Asian pension funds and insurance companies is over the duration of their fixed income assets: “Some are questioning how long a duration they want in their US treasuries. They are getting a bit more cautious. Pension funds and insurance companies need duration for ALM and have been investing in longer duration bonds” says Seth.
Relative to the US and Europe, Asian investors are very sensitive to credit risk, although as Baker points out, they are happier to take currency risk as they are used to dealing with many different currencies, which is the exact opposite to US institutional investors. Whilst central banks in particular, are wary of credit products, there is demand elsewhere for Asian corporate debt. Issuance was ~$65bn in 2010 and likely to be $70-80bn or higher in 2011 according to Seth, and high yield would account for around one third of the issuance which could go higher with the demand for hybrid securities: “The major high yield issuers are from China followed by Indonesia. The investors vary, with US and Asian investors interested in Indonesian natural resources, whilst if it is Chinese real estate, it would tend to have interest only in Asia.”
What they did have exposure to was structured products and bought AAA rated CLOs etc with 7-9% yields. One popular asset was US agency debentures from the US housing agencies, Freddie Mac and Fannie Mae. These were seen to have an implicit US government guarantee, but resulted in a marked-to-market loss when the agencies went into receivership: “This had political ramifications as Asian central bank had reached for yield moving out of US Treasuries into US agencies, but then the agencies ran into trouble.” says Baker.
The shift by central banks diversifying away from US treasuries is not very aggressive says Seth. As Baker argues: “In Asia, there are institutions that are by nature fixed income investors - banks with their liquidity requirements in both dollars and local currency, insurance companies and central banks. Pension funds are also core fixed income investors although they may move more into equities.”
What is happening though, is a longer term debate that central banks are developing of their asset mix: “We are seeing greater diversification into other asset classes including commodities and inflation linked debt, as well as spread products such as MBS. Some countries are more cautious than others and their central banks will only invest in G3 debt. We would expect sovereign wealth funds to take a longer term view, but the funds in the region have different levels of experience. Some have been around for 30 years, whilst others are more recent and are earlier in the process of developing their investment processes and outsourcing their assets.”