Investors begin to turn to Asian high-grade bonds

Investors begin to turn to Asian high-grade bonds

HONG KONG (Dow Jones): After months of wild swings in U.S.
asset markets, Asian bond investors are feeling more than a
little battered and bruised; the average spread on Asian
sovereign bonds widened to a 12-month high of nearly 300 basis
points over U.S. Treasurys in early April.

But in recent weeks, with U.S. bond and swap markets on
slightly steadier footing, some investors have started to venture
back into Asian bonds, although they're sticking mostly to
investment-grade sovereigns and quasi-sovereigns for now. As a
result, spreads on top-tier issuers such as Korea and Malaysia
have started to retrace recent losses.

"People are still interested in the fundamentals," says
Bernard Peh, corporate debt analyst at Barclays Capital, adding
that investors recognize these investment grade papers, now much
cheaper than they were three months ago, offer "good value and
good quality."

For example, the spread over U.S. Treasurys on the Korea bond
due 2008, rated BBB, has narrowed to 220 basis points from 242
basis points two weeks ago. The Malaysia 2009 has closely tracked
its Korean counterpart's performance.

Investors recognize that Asian fundamentals remain sound,
given the region's still-rising foreign currency reserves, ample
domestic liquidity, strong growth rates, and relatively tame
inflation.

Indeed, the weakness - and any significant recovery - in Asian
bond spreads is tied to U.S. asset markets, with U.S. dollar swap
spreads a key factor. The 10-year swap spread hit a high of 140
basis points earlier this year, before easing back down to 120
basis points this week. Many Asian financial institutions,
principally banks, swap fixed-rate instruments into floating rate
in order to better match their liabilities. Therefore, when swap
spreads snapped back in over recent weeks, so did Asian bond
spreads. -

While markets have steadied somewhat, more volatility is
expected ahead, at least through the next Federal Reserve
meeting, if not beyond.

"We remain quite cautious in the near-term because of the U.S.
equity markets," said Ivan Lee, head of corporate debt research
at Salomon Smith Barney in Hong Kong. He adds that Salomon is
forecasting a 50-basis point increase at the Fed's May FOMC
meeting. "Against this background, (there will be) continuous
pressure on Asian bonds."

Lee said he doesn't expect to see a rally in Asian bond
spreads in the short-run, although he agrees that the region's
fundamentals are solid and improving.

With this in mind, some analysts are recommending that
investors stick to their core holdings. Merrill Lynch says
investors should be in defensive mode, recommending they remain
overweight in sovereign issues out of Korea and Malaysia, and
quasi-sovereign bonds from Hong Kong and Singapore. These include
Korea 2008 and Malaysia 2009, as well as Hong Kong's MTR Corp.
2009 and Development Bank of Singapore 2009.

In particular, investors who ride out the volatility should
benefit from expected one-notch upgrades to BBB+ for Korea and
Malaysia that are widely expected later this year, Merrill Lynch
adds.

And given the prevalence of this view, investors aren't
willing just yet to venture back into sub-investment grade
territory, particularly after having been burned by the recent
meltdown.

Late last year, many analysts had recommended investors move
into higher-yielding Asian paper, on the assumption that Asian
sovereigns would remain expensive in relative terms.

However, just the opposite happened. The Philippines, rated
just below investment grade at BB+ by Standard & Poor's, has been
the worst-performing sovereign this year. The Philippines bond
due 2008, which has typically been yielding about 100 basis
points more than the Korea 2008, now has a spread differential of
around 230 basis points with the Korean paper.

Indeed, it may be difficult for Asian high-yield debt, or junk
bonds, to rebound, given the sizable outflows from U.S.-based
funds. Junk bond mutual funds now hold US$98 billion of assets,
down from last May's record $117 billion, according to AMG Data
Services. High-yield funds have seen net outflows for 16 of the
past 17 weeks, with investors pulling out $457 million last week
alone.

Barclays Capital sees a rally in emerging market spreads in
the next few weeks. With U.S. asset markets on steadier footing,
the securities house sees Asian bonds recovering strongly,
underpinned by strong economic fundamentals, with the Philippines
likely to bounce back the most.

Chase Manhattan, too, says the current weakness offers a good
buying opportunity, particularly in the high-yield paper such as
the Philippines.

"The Philippines is one of our favorite sovereigns in the
region," says Greg Batey, head of fixed income research at Chase.
"There's now 100 basis points difference between the Philippines
and Indonesia."

He adds that some Asian corporates, which have underperformed
sovereigns and quasi-sovereigns in recent months, are also ripe
for picking by investors, so long as they have a six to 12-month
horizon, which should get them past the current volatility. These
include Asia Pulp & Paper and Thailand's Total Access
Communications Pcl.

"I continue to think Asia (corporate bonds) will outperform
the U.S. investment-grade corporate bonds," says Batey.