This is a sponsored article from State Street Global Advisors.
Asia Pacific Head of Fixed Income
State Street Global Advisors
In response to higher inflation, the US Federal Reserve (Fed) and several other central banks have begun tightening their monetary policies. In its June meeting, the Fed announced a federal funds rate increase of 25 bps, to a range between 1.75% and 2%. It was the seventh rate hike since the tightening cycle began in 2015 and Fed officials expect to raise rates two more times this year, totalling four hikes in 2018. While we think the US rate hikes will continue to be gradual and largely dependent on economic data, around the world, easing might come to an end. So far, the European Central Bank and the Bank of Japan have signalled an intention to follow in the Fed’s footsteps and end their ultra-accommodative monetary policies soon.
Asian fixed income in a rising rate environment
So, will it be the start of a major bond bear market? The prospect of further Fed monetary tightening could dampen investor enthusiasm for fixed income assets; however, bearing in mind that inflation across Asia remains relatively subdued, the prospect of rate hikes in the region is likely to be gradual.
Furthermore, by ‘locking in’ low, long-term interest rates, issuers have lengthened the average maturity of their borrowing, which has consequently increased the average duration of investors’ portfolios.
Asian local currency government bonds, as measured by the Markit iBoxx ABF Pan-Asia Index, recorded a total return of close to 10% last year. In 2018, the positive trend has continued, though to a lesser extent, with smaller gains in Asian currencies against the US dollar.
Asian local currency bond returns tend to be driven by Asian currency performance. Against a backdrop of rising US interest rates, the US dollar is likely to strengthen. Although many Asian economies are now less dependent on dollar financing, it is still a significant funding source. If the dollar appreciates, this could weaken emerging market currencies, including those in Asia.
Positive fundamentals support long-term prospects
Nevertheless, US interest rates and the dollar are not the only factors affecting Asian currencies, and thus, the performance of Asian local currency bonds. The attractiveness of the region’s bond markets is also due to ongoing improvements in the underlying markets, including strengthening economic growth, low inflation, and healthy fiscal balances. In addition, authorities have taken the necessary steps to strengthen their respective economies. Measures include tightening regulation, recapitalising banking systems, and improving corporate governance. Various policy actions have bolstered fiscal and current account positions, which have resulted in credit rating upgrades in some Asian countries.
These positive fundamentals will continue to support Asian bond prices. Structural trade surpluses and growth differentials between Asian economies and developed countries will also exert upward pressure on currencies over the medium-to-long term, ultimately benefiting Asian local currency bond markets.
Other positive factors include relatively higher yields compared to developed bond markets, good diversification benefits given the low correlation of Asian local currency bonds with other developed bond markets, and attractive returns with moderate volatility.
Widened opportunity set
Many investors gain exposure to Asian fixed income indirectly, via global or emerging markets funds and mandates. However, with the Asian debt markets expanding rapidly, the opportunity set has widened.
One fast-growing segment of the market is bonds issued in local currencies — the Asian local currency government bond market has grown significantly in recent years, amounting to more than US$12 trillion in total issues outstanding as of December 2017; this compares to US$304 million in 1998.
We have witnessed over time that investors’ inflows into Asia have been increasing at a steady pace. Moreover, in April 2019 Chinese yuan-denominated government bonds and policy bank financial bonds begin their phased entry into the Bloomberg Barclays Global Aggregate Index. Other leading market benchmarks are likely to follow suit, further supporting capital inflows.
In the long run, the rise of the Asian economies and Asian bond markets will feature as part of the core allocation of global investors.
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This is a sponsored article from State Street Global Advisors.