Great rotation materialises in unexpected form

23 December 2013   Category: News, Asia   By Toby Garrod

Asia’s supply-driven bond markets are set for continued growth thanks to the rising need for sovereign bond issuance to finance massive and long-overdue infrastructure and a likely upturn in corporate bond issuance on the back of sustained low global interest rates, the implementation of Basel III, and continued European deleveraging. Meanwhile, deepening global interest among investors in these markets (both corporate and sovereign) is also clearly present.

What that means, say regional market players, is that the so-called ‘Great Rotation’, which assumed a return to the equity markets from the bond markets as the global economy moved into recovery mode, has been superseded by a ‘great’ regional rotation away from the Western bond markets into their Asian equivalents. It also suggests that the region’s bond markets may finally have come of age, and are here to stay in their new liquid and sophisticated form.

According to figures from Dealogic analyst Mandy Leung in Hong Kong, the total value of G3-currency Asian bonds issued between January 1 and October 31, 2013 stood at around US$136.5 billion, up about 11% compared to the same period last year ($122.2 billion).

“As the economy continues to grow, we are going to see continued demand for bond financing. Just in terms of infrastructure, there’s some $8 trillion of projects needing to be financed in the region,” says Thiam Hee Ng, a senior economist at the Asian Development Bank (ADB) in Manila. “With the new Basel III regulations, it’s going to be harder and more expensive for banks to finance these kinds of long-term projects; so there will be a greater reliance on the bond markets.”

This impact of Basel III on the regional bond markets should not be underestimated.

As Standard Chartered notes in its November 2012 white paper ‘Basel III Triggers Metamorphoses of Asian Corporate Funding’: “Under our base-case scenario, we expect a $66 billion equity shortfall for the Asia ex-Japan banking system over the next five years [due to the impact from Basel III regulation]. India’s banking sector accounts for $52 billion of this shortfall, with China’s banks making up the rest. The equity shortfall for each banking sector equals the increase in equity required (over and above internal capital generation) under the new Basel III regime, assuming that bank lending keeps pace with nominal GDP growth over the next five years. While we expect equity raising to cover some of this $66 billion shortfall, the stark fact of it will nonetheless reduce bank capabilities to continue to meet the demand for corporate financing.

“Under our base-case scenario, the cumulative financing gap for Asian corporates will be around $340 billion. Chinese banks account for $212 billion of this gap, with Indian banks filling in the rest. The financing gap is the cumulative shortfall in lending to corporates over the next five years resulting from the banks’ inability to raise equity to bridge the equity shortfall. We assume that this financing gap ($340 billion) will be filled by the bond markets.”

While market participants say the Basel initiative is already having an impact on corporate bond markets, a more specifically short-term growth driver is the rising number of issuers seeking to take advantage of lower global interest rates. Well-documented rumblings from the US Fed this year have reconfirmed enduring suspicions that post-crisis cheap financing is not in fact a permanent fixture of the financial landscape, leading companies to size up this moving window of opportunity for cheap funding. This explains the 11% growth in issuance cited at the start of this article.

Making demand

As noted, Asian markets have historically been driven by the supply side, which highlights the importance of the above transformations. Nevertheless, the demand side is also on the rise.

“Investors are getting into Asia for a variety of reasons,” says Kheng Siang Ng, Asia Pacific head of fixed income at State Street in Singapore. “Some for long-term reasons and some for short-term tactical reasons. The long-term money is going to be sticky as these people are looking to build up long-term exposures. Despite the volatility that we’ve seen from the Global Financial Crisis along with the Fed statements, Asian bond markets have ultimately gone from strength to strength. As the global economy continues to improve, investors from the West will feel increasingly comfortable investing in the region and that will offset the temptations of a return to strength in Western equity markets.”

Institutional investors are increasingly likely to enter the infrastructure-driven segment of the market. The long term-nature of these projects makes them a great match for the specifically long-term duration demands of institutional portfolios. This situation in turn is driving growth in the number of research teams that Western companies have based in the region to improve their market understanding.

Such trends are hardly surprising. Not only are returns in developing Asia still higher than in the Western world, but the region also enjoys the current benefits of a rebounding global economy.

“The Asian bond markets have traditionally been seen as volatile and unreliable,” says ADB's Mr. Ng. “But now they are considered to be much more stable and have much better economic policies and growth prospects, even through the recent crises. So they represent a very exciting investment opportunity for Western investors.”

“There were some structural issues in the past that deterred investors, but these have improved quite noticeably over the past few years,” says Arthur Lau, head of Asia ex-Japan fixed-income, and co-portfolio manager for emerging markets at PineBridge Investments. “For instance, many Asian countries lacked investment grade products, while sovereign bonds were often issued via local currencies. Meanwhile, the bond-issuing formats have not been friendly to US investors [for instance; Regulation S versus Rule 144A, where 144A assets are only accessible to qualified institutional buyers].”

One of the new drivers is the local-currency bond market, which up until recently has been largely avoided due to perceived risks. According to the ADB’s latest Asia Bond Monitor (published in June 2013), emerging East Asia’s local currency bond markets have expanded 12.1% year-on-year to $6.7 trillion at the end of March, driven by double-digit growth in corporate bonds.

“We should see further growth in the bond markets given that the region’s economies continue to expand as foreign and domestic investors become increasingly comfortable with Asian local currency debt,” said Iwan J Azis, head of ADB’s office of Regional Economic Integration. “Governments and companies are also much better now at managing their debt than they were a decade ago.”

As recent capital outflows from Asia, following the Fed statements, have highlighted, the biggest problem in Asia remains market volatility, which particularly affects shorter-term investors. While much of that money has now returned to the market [though whether the market actually wants such hot flows is another question], attention is more focussed now on how to reduce this volatility and strengthen the markets.

The main resolution will stem from growth within region, notes the ADB’s Mr. Ng: “To tackle the volatility, regional authorities [via the ASEAN+3 Finance Ministers Meeting held in August 2003] have been working to raise the presence of stable, regional market participants in the Asian bond market with the Asian Bond Market Initiative, which in turn will diminish the impact of hot money flows from the West.”

A self-made market

Ultimately, the goal is to create an Asia bond market that is an asset class unto itself, which means that regional securities must display shared attributes (for instance, correlations). Such unified regional features will only come once valuations are driven by growth from within the region rather than outside it, say the experts. Nevertheless, some key signs are already in place.

“Within Asia, there are many dedicated funds investing just within Asian markets,” says Mr. Lau. “It has its own indices for both USD and local currency bonds. Asia has CDS for countries, an index for hedging and investment purposes. So, in some forms, it does behave like an individual asset class already.”

What’s driving interest in Asia right now, however, is the giant China market; and the lion’s share of that interest is coming from outside the region.

There’s about $4 trillion currently outstanding in the Chinese bond markets, meaning it comprises about half of the entire Asia bond market. Current expectations about the rising value of the RMB and the continued strengthening of the Chinese economy mean that investors worldwide are very keen to get their hands on the stuff, which remains very much locked up for the time being.

The size of the China bond market is a function of the size of its banking system and the need for the Beijing government to manage the money supply, which looks set to grow for decades to come. As such, market participants clearly consider it part of the furniture in terms of Asian capital markets. The big question is: ‘When is it going to open up?’

“The doors are about 99% closed at the moment,” says State Street’s Mr. Ng. “When the doors are open we will see the full extent of how the China market will influence the regional markets. We are seeing some liberalisation measures being introduced by China, via Hong Kong. And over time, we will start to see real dominance in regional capital markets. Of course the capital account needs to be liberalised, and when that happens it will drive a lot more liberalisation.

“China’s exact role in Asia’s future bond market is not clear cut, however. At the moment international investors are already investing in selected Asian markets, such as Singapore, Hong Kong, Korea and Thailand. Meanwhile, other countries, such as Indonesia, are on the emerging market bond indexes. So to some extent international investors have already been investing into Asia regardless of whether China is open or not, because the region as a whole has been developing over this time. When China opens up, however, we will likely see a re-routing of flows from the rest of Asia into China, as investors seek additional diversification options and the possibility of better returns.”