Enhancing Asian Bond Returns via a Blended Approach

Market Views And Insights | September 12, 2017

Endre Pedersen, Chief Investment Officer, Fixed Income, Asia ex-Japan

Asian bonds are rising in popularity. Vibrant economic growth, coupled with competitive yields and increased credit issuance across the Asian region, has garnered robust investor interest. Investment approaches to Asia’s bond markets, however, are not all equal.

In this note, Endre Pedersen, Chief Investment Officer, Fixed Income (Asia ex-Japan), discusses why adopting a blended approach to Asian bonds could be the best route to sustainable income for investors. Pedersen describes the benefits of combining exposures to both Asian local currency and Asian dollar bonds (USD-denominated bonds from Asian issuers), and also explains why Manulife Asset Management (MAM) is uniquely placed to execute this strategy.

What is the blended approach to investing in Asian bonds? What are MAM’s unique strengths in executing this strategy?

By a blended approach, we are referring to our Asian Total Return strategy of investing in both Asian local currency and Asian dollar bonds to exploit opportunities across interest rates, credit, and currencies.

Combining local currency and dollar-denominated bonds presents an expansive investment universe of Asian government and government-related bonds, as well as corporate bonds issued by fast-growing and blue-chip Asian corporations across many sectors. Typically, local currency bonds are issued by Asian governments e.g. Indonesian sovereign bonds. US dollar-denominated bonds are mostly issued by Asian corporations (including large blue-chip companies as well as smaller emerging companies). Depending on the team’s currency views, we can also participate in the currency component of local currency bonds by controlling the amount of currency hedging in the portfolio.

This blended approach to investing in Asian bonds leverages MAM’s strengths in top-down macroeconomic analysis as well as bottom-up credit analysis, supported by an extensive on-the-ground team of portfolio managers and credit analysts from 10 different Asian markets.

Our risk management heritage helps us to effectively identify the best opportunities across both local and USD-denominated markets whilst prudently managing downside risk.

Three key return drivers for our Asia Total Return Bond Strategy

How does a blended approach impact portfolio risk?

Besides an expanded opportunity set, another benefit of adopting a blended approach is improved diversification. Portfolio theory states that a combination of investments that are not perfectly correlated, in this case local Asian bonds and Asian dollar bonds, can lead to lower risk.

The application to a blended portfolio of Asian bonds can be illustrated through an example. If we look at the returns and volatility over the past 10 years (July 2007 to July 2017) for Asian dollar bonds and Asian local currency bonds, a hypothetical blended portfolio (50% Asian dollar bonds and 50% Asian local currency bonds) would have achieved lower overall portfolio risk (Figure 1) than portfolios invested in 100% of either Asian local currency bonds or Asian dollar bonds.

Figure 1: Risk (Measured by annualised standard deviation from July 2007 to July 2017)1

Can you provide some examples of when one approach outperformed the other, i.e. Asian local currency bonds vs. Asian dollar bonds?

During episodes of credit spread widening, corporate bonds will typically underperform government bonds as wider credit spreads have a negative impact on returns. The Global Financial Crisis (2007-2008) is a good example of when spread widening favoured local currency bonds.

With credit spreads initially below 200 basis points (bps), spreads progressively moved higher as contagion spread across global markets — the JACI index (which represents Asian Dollar Bonds) peaked at 765 bps in November 2008. Between August 2007 and December 2008, the JACI index returned -5.7%, while the ALBI index (which represents Asian Local Currency Bonds) gained 5.1% over the same period. Within the same Asian bond universe, the return difference could be as high as 10 percentage points. In this scenario, an extreme "risk-off" event affected multiple asset classes; however, it was a clear example of when Asian local currency bonds outperformed Asian dollar bonds as credit spreads widened dramatically.

Figure 2: Asian local currency bonds provided a buffer when spreads widened in 20082

Scenario 2: Asian dollar bonds outperformed during 2013’s "Taper Tantrum"

The "Taper Tantrum" is a good example of Asian dollar bond outperformance. Between April and December 2013, markets believed that the Fed might embark on the tapering or reduction of its quantitative easing programme. This took markets by surprise: US 10-year treasury rates rose very quickly from 1.67% in April to finish the year at 3.0%.

The rapid spike in US treasury yields had an adverse effect on most fixed income asset classes. Over this period, however, Asian dollar bonds outperformed Asian local currency bonds; the JACI lost 1.6% while the ALBI was down 6.3% (see Figure 3). Despite higher rates, credit spreads were relatively stable and mostly offset the negative impact from rising treasury yields. On the other hand, the ALBI suffered more as investors pulled funds from emerging markets due to concerns over the impact of higher rates. The depreciation of Asian currencies also compounded the negative returns.

Figure 3: Taper Tantrum in 2013 – Rapid rise in Treasury yields triggered outflows from EM bonds3

Scenario 3: Asian local currency bonds outperformed as Asian currencies gained against the US dollar

From May 2010 to August 2011, a time when US interest rates and credit spreads generally declined, Asian dollar bonds and Asian local currency bonds performed strongly. Figure 4 shows Asian local currency bonds (+14.7%) outperformed Asian dollar bonds (+10.4%), as Asian currencies rallied 5.9% against the US dollar over this period (as measured by the Asian dollar or ADXY index).

Similarly, the ALBI benefitted from Asian currencies gaining against the US dollar since the beginning of this year, contributing to local Asian currencies outperformance.

Figure 4: Appreciating Asian currencies helped outperformance for Asian local currency bonds4

These three examples highlight different periods over the past 10 years when one asset class of the blended portfolio outperformed the other. As returns are not perfectly correlated and global markets experience changing cycles, a blended approach can reduce overall portfolio risk and help smooth overall returns for investors.

Can you elaborate on the types of trades or strategies you implement within your blended investment approach?

We generally categorise our trades under three main strategies or performance drivers including: (a) Interest rates; (b) Credit; and (c) Currency.

The following are examples of trades that may be adopted under each performance driver:

  1. Interest rates: This could involve selecting bonds that offer higher coupons for income or selecting bonds where interest rates are declining, which can result in capital gains. Our blended approach ensures we will have views on local interest rates across the key Asian local bond markets.
  2. Credit: This refers to holding corporate bonds in the portfolio. Typically, returns are generated if credit spreads tighten, reflecting improving fundamentals for a company (e.g. if there is a credit rating upgrade), or if the macroeconomic environment has improved and there are more flows into the asset class. While we can and do participate in Asian corporate bonds denominated in local Asian currencies, the Asian credit market is dominated by bonds denominated in US dollars.
  3. Currency: Again, with our blended investment approach, our Asian bond team may choose to take risk-controlled views on the trend for Asian currencies vs the US dollar or trends within individual Asian currency pairs to contribute to total returns. Currency views consider the team’s top-down country-level analysis as well as evidence of mispricing.

 

Although certain strategies will perform better under different market conditions, our blended approach to Asian bonds ensures our portfolio is well diversified in terms of exposure to the three underlying strategies described above. Furthermore, based on our strategy’s track record, there is clear evidence that our Asian bond team has achieved this diversification while generating excess returns across all three performance drivers.

For the remainder of 2017 and looking ahead into 2018, what is your outlook for Asian bonds and where do you expect to see the most value?

Central bank policies will be in the spotlight over the second half. In the US, we think the Fed will continue to gradually normalise monetary policy and begin unwinding its balance sheet on the back of economic strength, buoyed by strong employment numbers and solid company earnings. With stronger growth and lower political risk in Europe, the European Central Bank (ECB) may also look to begin tapering of its quantitative easing. These potential moves by major central banks will be closely watched by the market along with the potential to cause volatility.

In Asia, we expect the strong first half growth experienced in China will allow the People's Bank of China (PBoC) to continue deleveraging efforts. While Asian economies have benefitted from the recent uptick in global demand, domestic conditions remain challenging and Asian central banks retain a bias to accommodative monetary policy. Given this backdrop, we see better value in interest rates, followed by credit and then currencies.

 

  • Asian interest rates: We continue to favour-higher yielding local currency bonds, including Indonesian and Indian government bonds, which are attractive for their carry and total return prospects. Indonesia continues to attract foreign investor flows with improving economic fundamentals. Meanwhile, India is expected to benefit from domestic tax reforms and a low inflationary environment, which leaves room for further rate cuts that will benefit Indian government bonds.
  • Asian credit: Both Asian investment grade and Asian high yield bonds have seen decent spread tightening since the start of the year. They are trading at relatively tight levels driven by strong local demand. The high yield market in particular has been tested by volatility around a commodity industry-related issuer, whose bonds have sold off. But there has been little contagion to other high yield names with the market recognising the idiosyncratic nature of the event. Looking ahead, we will continue to selectively add to names where we like the fundamentals and see value. We also look to take advantage of a strong new issue pipeline for the remainder of the year.
  • Asian currencies: We remain defensively positioned in the current environment. Softer economic fundamentals and the risk of trade protectionism could negatively impact Asian currencies from export-led economies in the medium term.

 

Overall, we remain prudently positioned given uncertainties to the global environment but expect the Asian bond asset class to be well supported and on track to continue delivering attractive income and returns for investors. Furthermore, we believe a blended and dynamic approach to Asian bond investing is well-suited to both the current environment and in the year ahead, given that macroeconomic uncertainty is set to persist.

1 Bloomberg, Manulife Asset Management, indices used are Markit iBoxx Asian Local Bond index and JP Morgan Asian Credit Index, July 2007 to July 2017.
2 Bloomberg, Manulife Asset Management, indices used are Markit iBoxx Asian Local Bond index and JP Morgan Asian Credit Index, 31 July 2007 to 31 December 2008.
3 Bloomberg, Manulife Asset Management, Indices used: Markit iBoxx Asian Local Bond index; JP Morgan Asian Credit Index; US 10 Year treasury yield, 29 March 2013 to 31 December 2013.
4 Bloomberg, Manulife Asset Management, indices used are Markit iBoxx Asian Local Bond index and JP Morgan Asian Credit Index, 30 April 2010 to 31 August 2011.

About the Author

2017 Sep Pedersen Endre Endre Pedersen

Chief Investment Officer, Fixed Income, Asia ex-Japan

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