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.