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Underpinned by the rise of China, Asia is home to some of the fastest-growing economies in the world. While the region represents nearly a third of the global gross domestic product (GDP), it’s underrepresented in global bond indices. According to investment management firm KraneShares, Asia ex-Japan accounts for just 12% of the Bloomberg Global Aggregate Index. At the same time, regional fundamentals are strong, and Asia bonds can be explored despite rising rates thanks to their higher yield and higher credit spread compared to the US and the Global Aggregate Index. However, substantial risks remain from faster-then-expected US Federal Reserve rate hikes, persistent inflation, rising commodity prices, the Russia-Ukraine war, and slow recovery in China’s economy.
Market development
Fixed income markets in Asia were underdeveloped going into the 1997-98 Asian financial crisis. Over-reliance on short-term bank borrowing eventually led to the inability of corporations to roll over debt. After this lesson, significant efforts were made to facilitate large, open and liquid fixed income markets.
Asian Bond Markets Initiative and the Asian Bond Fund (ABF) played a significant role in the development of the Asian fixed income markets. ABMI focused on the issuer side, increasing the breadth and diversity of issuers. In comparison, ABF worked on improving liquidity in major government bond markets and removing some of the barriers for foreign investment.
Over the last two decades, most Asia Pacific economies were able to successfully transition to interest rate-based monetary policy. Fixed income markets allow central banks to efficiently channel policy rate adjustments to the real economy. The opening up of the Asian bond market also led to foreign capital flows, including into long-term local currency bonds, diversifying source of funding for Asian governments.
Asia bonds: market size and composition
Partially due to these policy initiatives, Asian fixed income markets have grown from less than $250 bn in 1995 to $23.5 tn at the end of March 2022. This is a nearly $5 tn gain over the past two years despite the economic slowdown seen during the pandemic.
Local currency (LC) bonds continue to be dominated by quasi-sovereign and sovereign issuers. In fact, government bonds made up 63.1% of Emerging East Asia’s outstanding LC bonds, totalling $14.5 tn. LC government bond issuance grew 25.9% quarter-on-quarter to $1.6 tn during the quarter ended June 2022, supported by government borrowing.
However, private sector bond issuance fell 4.9% quarter on quarter as weak economic outlook and rising borrowing costs dampened sentiment. LC corporate bond market is also emerging, with the average annual growth rate of 40%, between 2001 and 2019.
Weak economic outlook dented investment appetite, with the sustainable bond market in ASEAN+3 countries expanding slower during the second quarter of 2022 to hit $503.5 bn. Issuances contracted by 5.2% during the quarter, with the sustainable bonds outstanding as a share of global market slipping to 15.3% at the end of June, down from 16.7% in March.
Inflation, monetary tightening and Asian bonds
Monetary policy tightening and increased price pressures have pushed Asian bond yields higher. The weakness in Asian financial markets can be seen by losses in equities, widening risk premiums, and depreciation of several Asian currencies against the US dollar. High inflationary pressures in the US have led to hefty rate hikes by the US Federal Reserve, and the market expects the federal funds rate to exceed 3.25% by the end of 2022. The European Central Bank too raised key interest rates last months, the first hike in over a decade as inflation started to bite.
While some Asian countries have raised rate in response to the steep rate hikes in the US, Bank of Japan (BOJ) has remained dovish despite the yen hitting multi-decade lows. Japan grew 3.5% year-on-year during the second quarter of 2022. The BOJ expects higher inflation, which it believes will be good for the economy which has seen negative interest rates for years.
During February 28 and June 9, the Philippines saw the largest increase in 10-year government bond yields in the region at 140 bps, whereas 2-year yields rose 112 bps after the central bank raised interest rates by 25 bps. Malaysia’s central bank announced a surprise rate hike of 25 bps in June and another 25 bps in September. The Bank of Korea has delivered multiple rate hikes this year, the last one being by 25 bps in August. Singapore and Thailand too have hiked interest rates anticipating inflation pain.
Incidentally, China has stayed on course of its easing monetary policy with bond yields being largely unchanged. Beijing is in fact trying to increase liquidity in the market by increased corporate lending and providing fiscal stimulus. In August, the PBOC cut its five-year loan prime rate by 15 bps to 4.30%.
Impact of US policy decision on developing Asian markets
Asian Development Bank (ADB) in its bond market report says, “The risk to the outlook of regional financial conditions is tilted to the downside. Moderating economic growth remains a key short-term risk, together with mounting uncertainties regarding inflationary pressure, the pace of the Federal Reserve’s monetary tightening, lingering impacts of the pandemic, potential spillovers from a faster-than-expected slowdown in the PRC, and the possibility of greater-than-expected spillovers from the Russian invasion of Ukraine.”
Studies cited by ADB show that monetary policy tightening by the US led to Asian economies witnessing significant currency depreciation over the next one to six months, and an increase in 10-year government bond yields over the next three to six months. Whereas quantitative easing of increase in asset holdings of its System Open Market Account (SOMA) triggered currency appreciation for the first month and a decrease in bond yields over the next one to three months.
China continues to dominate
The local currency market in emerging East Asia grew 3.1% quarter-on-quarter to reach a size of $22.9 tn at the end of June, same as the growth of 3.1% seen in the previous quarter. Overall, emerging East Asia’s LC bond market grew 14% year-on-year.
China continued to dominate the Asian fixed income market, representing over 80.2% of the region’s total LC bonds outstanding. South Korea has the second-largest local currency bond market with an overall share of 9.8% in Q2 of 2022.
China, South Korea, Malaysia, the Philippines, Singapore, and Vietnam saw an increase in their respective government bonds-to GDP share. On the other hand, for corporate bonds, only the People’s Republic of China, Hong Kong, China, Thailand and Vietnam posted an increase from Q1 2022 to Q2 2022.
Foreign holdings of LC bonds declined in most East Asia economies during the pandemic. Investor sentiment has been weighed down by aggressive monetary policy tightening by the US Fed, the Russian invasion of Ukraine, steep global commodity prices and a slowdown in China’s economic growth.
During the second quarter of 2022, the region saw a record $21.5 bn of net foreign outflows from the bond market. June saw the biggest sell-off as nearly all markets, except the Philippines, recorded net outflows. The People’s Republic of China saw the worst of it, with net outflows of $6.2 bn, $2.1 bn and $8.3 bn in the months of April, May and June, respectively. Diverging monetary policies of the People’s Bank of China and the US Federal Reserve led to an exodus of foreign money from PRC’s bond market.
However, issuances in emerging East Asia LC bond markets continued at a robust pace and remained above than pre-pandemic levels to reach $2.4 tn in Q1 in 2022. The PRC saw the largest increase in regional bond issuance, whereas South Korea was a close second. ASEAN markets had a collective share of 17.5% of the emerging East Asia’s bond issuances.
Asset managers with Asia expertise
There is no lack of asset managers with deep expertise in managing Asia fixed income funds. Blackrock has a $3.6 billion Asian Tiger Bond fund, the DWS Invest Asian Bonds fund has $1.5 bn in assets under management. Other fund managers include Allianz, Eastspring Investments, Fidelity, Neuberger Berman, Matthews Asia.
Most asset managers also appear bullish on Asian fixed income. HSBC, in its mid-year investment outlook report says that there is less upside for bond yields and the US dollar from here, and short dated corporate bonds are the most attractive. However, the asset management firm says it sees attractive opportunities in the Asian credit market after the sharp correction seen over the past year. “We have a strong preference for Asian IG and RMB bonds over Asian high yield for their quality appeal and are enticed by the yield pick-up versus DM and other EM IG credit,” says HSBC in its report.
Pinebridge Investments in its mid-year Asia fixed income outlook report says that the recent volatility seen in Asia high yield (HY) market will subside in the next few months on the back of steady credit fundamentals for non-Chinese issuers. “US dollar-denominated Asia investment grade (IG) bonds stand out for their track record of having lower volatility and better returns than US IG credit and emerging market (EM) bonds, making them an attractive diversifier in volatile markets,” Pinebridge said in a separate insights statement.
Asia bonds: time for a dedicated asset allocation
Asian fixed income offers investors exposure to the accelerating economies across the region at sustainable valuations and with higher yields relative to similarly rated global bonds. Furthermore, Asia fixed income usually exhibits lower volatility and better risk-adjusted performance compared to other Emerging Markets. While challenges remain, there’s a strong argument for a dedicated asset allocation to Asian fixed income.
