Last updated: 15:51 / Monday, 30 November 2015
Interview with Matthews Asia

Asian Fixed Income: A Market of Adequate Size and Depth, but is it the Right Time to Invest?

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Asian Fixed Income: A Market of Adequate Size and Depth, but is it the Right Time to Invest?
  • In an interview with Funds Society, Teresa Kong reveals the challenges and opportunities of Asian fixed income
  • Matthews Asia upholds the attractiveness of markets with lower levels of debt and better credit quality, such as Indonesia, China, and Sri Lanka.
  • The volume of the Asia ex-Japan local currency debt market now equals three-quarters of the US Treasuries market.
  • "We have to think of China more as a developed market than an emerging one, so growths of 5 % are far more plausible."
  • For Asian currencies Kong does not foresee a collapse similar to that of Latin America or Eastern Europe Asia
  • The strategy led by Teresa Kong is unconstrained, therefore, depending on market expectations, they can move from US Dollar denominated debt to debt denominated in local currencies.

Latin America fully understands the challenges of investing in Asia, as well as its volatility. Used to 15% yields in the bond market, they also know that such returns come hand in hand with volatility more akin to equity market investing. In other words, Latin American investors are used to sleepless nights because of the markets. This makes Teresa Kong, lead manager of Matthews Asia’s, Asia Strategic Income Fund, feel more comfortable talking to a Miami or LatAm investor about her specialty, Asian ex-Japan fixed income, than to a typical domestic US market investor. In an interview with Funds Society, Kong reveals the challenges and opportunities of Asian fixed income, an asset class that, according to the expert, is under-represented in global fixed income portfolios.

How big is the Asian debt market?

If when investing in emerging debt, we trusted the indices, we would just basically invest in three markets: Russia, Brazil and Mexico. These are the three countries with most debt issued, but not necessarily those with better credit quality or better interest rates prospects and local currency developments. In fact, according to these parameters, Matthews Asia upholds the attractiveness of markets with much lower levels of debt and better credit quality, such as Indonesia, China, and Sri Lanka. Active management prevails.

The Asia ex-Japan local currency debt market was very small twenty years ago, but development has been immense, and its volume now equals three-quarters of the US Treasuries market. According to data from Asia Bond Monitor, in 2014, this market totaled US$8.2 trillion, compared with the US$447 billion it had in 1997. "With its current size, it’s not a market that can be ignored," said Kong.

The size of this market, however, is not well reflected in the global benchmarks. For example, the Barclays Global Aggregate Bond index allocates only 3% to Asian fixed income ex Japan.  “That is very small when you consider the fact that Asia accounts for a third of world GDP and half of global GDP growth."

"Not only must we understand the magnitude of this growth, but also its quality," said Teresa Kong. The growing middle class in Asia is an unstoppable phenomenon, and is accompanied by a boom in consumption, which is affecting various industries: insurance, real estate, automotive etc. These companies need funding in order to grow, which explains the extraordinary development of the Asian emerging market debt. “Furthermore, there is now also an internal institutional demand for sovereign debt in local currency. Local insurers need to invest their premiums on long-term debt instruments with maturities to match their obligations. Thus, we see how, Indonesian insurers, for example, have become natural buyers of sovereign debt in their own local currency."

A market with volume and depth, but is it the right time to invest?

There are three sources of risk and return in the Asia fixed income market- interest rates, credit, and currencies.

Over the past three years, we have seen a strengthening of the dollar which in recent months has been accompanied by a rise in debt yields in the United States. As a result, the carry trade strategy (borrowing money in markets with very low rates, such as Europe and, until recently, the United States, to then invest in countries with higher interest rates, as in some emerging markets) has been losing steam.

All of this coincides with the bursting of the commodities' “super cycle” for which China is partly responsible by lowering their growth expectations. "We’ll never see China growing at 7.5 % anymore," said Kong. "We have to think of China more as a developed market than an emerging one, so growths of 5 % are far more plausible."

For one thing, dependence on commodities by Asian economies is inversely proportional to its price. Unlike in Latin America, almost all countries are net importers of raw materials, so they have benefitted from falling commodities prices.

Linked to low inflation across most of Asia, Kong sees room for interest rates to continue to fall.  And, at current credit spread levels, making a long-term investment in Asia credit has historically made sense. 

Looking forward, Kong suggests that Asian economies are much more geared to domestic consumption. "The middle class is a reality. In China, over the next ten years we will be much more focused on analyzing domestic consumption data, than that of either exports or inventories. In Latin America, or even in the Middle East, with commodity prices, especially oil, at current levels, it will be very difficult to create wealth."

Local currencies have been oversold and are looking attractive

As for Asian currencies, although they have experienced depreciation over the last two years, Kong does not foresee a collapse similar to that of Latin America or Eastern Europe Asia because, "in general the current account balances are strong, and there is not a massive participation of foreign investors in the debt markets, with a few exceptions, such as Indonesia, where 35 % of the debt is in international hands, explaining the increased volatility in the exchange rate of the Indonesian rupiah.”

Asian currencies will not fall as much as Latin American ones, as the next 5-10 years will be much better for Asian economies than for those of Latin America," said Kong.

The strategy led by Teresa Kong is unconstrained, therefore, depending on market expectations, they can move from US Dollar denominated debt to debt denominated in local currencies.

Until September, they held 70% of the portfolio in US dollar denominated debt, given the strength of the currency, but since then they have been increasing their exposure to certain currencies such as the Malaysian ringgit and the Indonesian rupiah, which have faced a punishment that the team considers excessive.

Worried about what Yellen might do? Asian debt offers de-correlation in relation to Treasuries

An additional feature of Asian fixed income, ex Japan, is its low correlation with US Treasuries. The beta of the asset class in relation to Treasuries is 0.50 -0.37 if we only consider the local currency debt- While US investment grade bonds have a beta of 0.70 in relation to Treasuries and the correlation of G8 bonds is even greater. "If you're worried about the volatility that the Fed can generate in the coming months, the incorporation of Asian bonds in the portfolio, is a factor to consider when diversifying," said Kong. "It can serve as a relatively safe haven against rate hikes in the United States."

This strategy is worth considering to diversify a fixed income portfolio, but why opt for a fixed income fund focused on Asia ex Japan, instead of investing in one of global emerging debt? "Latin American investors normally already have a significant position in fixed income from their own region, often through direct investment in corporate bonds of Latin American companies. If they invest in a global emerging debt strategy, the result will be that they double their exposure to Latin America, which in the current market environment may not make sense. We believe it is more interesting to complement exposure to emerging market debt with a differentiated strategy that invests in the Asia ex Japan region," explained Kong.

A yield-generating strategy, but with controlled volatility

The U.S. version of Asia Strategic Income Fund, domiciled in the United States, was launched in 2011, and in its Luxembourg version for offshore clients, was launched by the end of 2014. It was created with the aim of becoming an alternative to income generating asset classes, but with controlled volatility. "We are more similar to a U.S. High Yield that to an emerging debt fund," said Kong. The strategy seeks to generate alpha from currencies, interest rates, and credit and to generate attractive risk-adjusted returns.  Since its inception in 2011 the volatility of the US fund has been half to one third of that of the emerging markets debt indices.  

Despite being an "unconstrained" strategy, it follows a series of parameters to manage portfolio risk: on the one hand, 80% of the portfolio must be invested in Asian debt ex Japan, leaving only 20 % for opportunities in which the team can opt for convertible bonds or even equity. On the other hand, no more than 15% of the portfolio can be concentrated on a single currency or interest rate regime, "introducing tighter control than what you have when investing in the index, which gives some currencies, such as the Korean, a weight of over 20% ".

The Asian fixed income team led by Teresa Kong consists of four people and has the support of 40 Matthews Asia professionals dedicated exclusively to the research and management of investments in Asia. "We sit next to the teams which follow Asian equities, and our exchange of ideas is constant," explains Kong. They also travel with equity teams to visit both companies and institutions in the area, several times a year, leveraging the resources which Matthews Asia allocates to these markets.

Recently, Matthews Asia has launched its second fixed income strategy, the Asia Credit Opportunities fund, also managed by Teresa Kong’s team. This Luxembourg-domiciled fund focuses primarily on credit issues denominated in dollars in the Asia ex Japan region. Such issues make up 80 % of its assets.
 

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