This is the reproduction of an article in IFR Asia magazine.

In the face of formidable uncertainties this year, investors may still seek the comfort of fixed income, says Dilip Parameswaran

Despite all the misgivings at the beginning, last year turned out to be a good one for fixed-income investors. Asian dollar bonds ended the year with a return of 5.8%, composed of 4.5% for investment-grade and 11.2% for high-yield bonds, according to JP Morgan Asia Credit Index data. We are beginning another year full of uncertainties. What does 2017 hold in store for fixed-income investors?

The first big uncertainty relates to the path of US interest rates. The Fed has begun raising rates and has signalled that three rate increases are in the offing this year and three more next year. A sustained period of job growth has brought US unemployment down to 4.7%, but more importantly the pace of wage increases to 2.9% per year. While these numbers underpin the Fed’s planned rate increases, the key unknown is the impact on any potential fiscal stimulus on growth and inflation.

That brings us to the second key uncertainty: the Trump administration’s plans for the economy. It is widely understood that the next administration intends to provide fiscal support through a cut in taxes and an increase in infrastructure spending, but the extent of the stimulus and its potential impact are unknown. If these plans start nudging inflation up to a level higher than the Fed’s current expectations, the Fed might have to respond by raising rates faster.

Another unknown is the extent to which the Trump administration’s policies on trade and the dollar will influence key economic variables. Mr Trump has espoused various protectionist views and may tolerate a weaker dollar. While a weaker currency might push inflation higher, the final impact of protectionist trade policies, particularly on growth and employment, is uncertain.

China is the other piece in this moving puzzle. At the beginning of last year, worries about China’s economy dominated the markets, but as time went on, growth began to stabilise and greater uncertainties – including the US presidential election – took over. This year too, the markets are resting on the comfortable assumption that China would manage growth of about 6.5%.

But China still faces a myriad of economic issues, all of them carried over from the last year. While economic growth last year was propped up by continued flow of credit to the economy, the total debt in the system has reached close to 300% of GDP, according to various estimates. China also faces the challenge of rising capital outflows in response to slowing growth and a depreciating currency. While property construction was a key support for the economy last year, property prices in many cities have risen to such unsustainable levels as to prompt a round of regulatory constraints. The government may provide a measure of support to the economy through an expanded fiscal deficit, but it would exacerbate the challenge of managing the total debt in the economy. On top of all these domestic economic issues, there is the added challenge of a strained trade and political relationship with the US. China may yet emerge as one of the key trouble spots this year.

Where does all this leave the fixed-income investor in Asia? We believe that Asian dollar bonds could again produce positive returns of 2%-3%, without leverage.

One key driver of the returns is, of course, US Treasury yields. Based on the current expectations for the Fed rates, we believe the 10-year yields could rise by about 50bp over the year to reach close to 3%.

The spreads on Asian dollar bonds narrowed by about 25bp last year for investment-grade and 130bp for high-yield bonds, according to the JACI data. This year, we expect investment-grade spreads to finish flat and high-yields bonds to widen by 50-75bp. This is primarily because the positive performance last year has left Asian spreads somewhat tight by historical standards and in comparison with US spreads.

Credit defaults are unlikely to turn into a big issue for Asian bonds. Moody’s expects that, after a temporary pick-up in the early part of the year, the global high-yield default rate will edge down from 4.4% to 3% over the year. In Asia, defaults have always been episodic and not systematic. Given the prevalence of family ownership, government connections and bank support, Asian issuers have averted defaults in many difficult situations.

The technical factors for Asian bonds were strong last year. Nearly three-quarters of Asian bond issues were placed within Asia, up from 63% the year before. Support from Chinese investors in particular has been one of the contributing factors. We expect these factors to continue supporting the market this year as well.
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While some market players expect a wholesale shift of funds to equities this year, the so-called “great rotation” has so far proved to be the wolf that never came. With major uncertainties confronting the economic world this year, investors might yet prefer the cosy comfort of fixed income for a while yet.

This is the reproduction of an article in IFR Asia magazine.

One of the key constraints for the Indian economy is the accumulation of non-performing loans in the banking system. Recent figures from the IMF show that, at 5.9%, India’s gross non-performing loans as a share of total loans are the highest in Asia. Including restructured loans, the figure exceeds 14%.

As banks groan under this burden, they are unlikely to be able to support the lending growth required for the economy to pick up. The Reserve Bank of India has taken the first step towards a solution by conducting asset-quality reviews and insisting that all the non-performing loans be recognised for what they are. It has imposed a deadline of March 2017 for the banks to properly classify loans and make provisions.


While this may increase the stress on the profitability and capital ratios of the banks, it is better to accept the truth than to brush it under the carpet. The capital ratios of Indian banks are already among the lowest, according to IMF, and will come under further stress as the banks go through the inevitable pain. While the government has allocated some funds to recapitalise banks, this is by no means sufficient.

Apart from pushing for greater transparency, the RBI has allowed banks to convert loans into equity with a stipulation that they have to find a buyer for the shares within the next 18 months. The challenge for the banks is to convert the debt to equity at a high valuation, manage the companies in the interim, and identify a buyer. The RBI permits the banks to sell as little as a 26% stake while holding the rest, but potential buyers may not like keeping the banks as co-owners for an extended period.

The RBI has also allowed banks to refinance loans to the infrastructure sector for 25 years with refinancing or restructuring every five years. The question is whether banks will apply this option to viable loans or to mask problems.

However, none of these solutions is a genuine attempt to improve the viability of troubled borrowers. If India’s bad loan problems are to be resolved in a meaningful way, a host of supporting systems need to be developed. The recently enacted bankruptcy law goes some way in offering solutions for the resolution of insolvent companies, but more changes are required.

First of all, banks need the freedom to deal with problem loans in the best way possible. Currently they are averse to writing off loans or to sanction additional credit for troubled companies for fear of being accused of underhand dealings. The current RBI regulations are far too constraining for them to try to revive distressed borrowers, as they impose a time limit on re-sales of equity shares acquired through debt swaps, lay down the equity valuation method, and specify the minimum percentage to be sold.

India also needs to develop a strong culture of evaluating credits before the loans are sanctioned and for monitoring the borrowers for early-warning signals of trouble. In this context, it is interesting to note that it is not small-scale industries that have led to this massive accumulation of bad loans, but the medium and large-scale borrowers. So the question can justifiably be asked why the banks tolerated the build-up leverage and not take action sooner.

The concept of independent insolvency professionals introduced in the new bankruptcy law is a positive move, but they need to come from a variety of industrial management, finance and turnaround backgrounds, rather than merely the legal profession. This will happen only if banks are willing to entrust management of troubled industries to turnaround professionals rather than lawyers with expertise in dissolving companies, backed by appropriate incentive structures. For example, banks may agree on an incentive compensation based on an objective measure of improving the value of the borrowers’ business such as a multiple of Ebitda or on specific actionable measures such as completion of specific projects.

Although asset reconstruction companies have existed in India for many years, they are modest in size compared to the scale of the problem. They have also enjoyed a favourable system of putting up a cash outlay of only 5% (recently increased to 15%) and charging a management fee of 1.5%-2% of the asset value. In addition to this model, other models of outright sales, incentive payments and sharing of recovery values would encourage reconstruction companies to maximize recoveries. Unlike China, India could also consider investing public funds in asset reconstruction companies in order to provide a speedier resolution to the problem.

​Any amount of tinkering with rules on recognition of problem loans and provisioning is not likely to lead to a genuine revival or resolution of bad loans. To achieve that, the mindset has to change across the entire range of stakeholders, including banks, turnaround funds, professionals, and even the government.

This is the reproduction of an article published in the IFR Asia magazine.

Asian bonds are yet again likely to generate positive returns this year and provide a measure of stability to investors’ portolios, says Dilip Parameswaran

The year has not exactly started well for many asset classes. Oil has sunk to prices not seen in the last 12 years. With another sudden downward lurch in its currency, China has injected more concerns into the market about its economy, dragging other commodities further down. Equity markets have taken fright, with the Dow already down 9% since the start of 2016.

Against this background, there is one question on the mind of every investor: “With the Fed poised to raise again this year, what does the future hold for fixed-income investments?” In our assessment, the answer is not as negative as you might think: US dollar bonds from Asia can generate a total return of 2%–4%, without leverage.

Last year, Asian bonds generated a total return of 2.8%, split into 2.2% for investment-grade and 5.2% for high-yield bonds, according to JACI index data. This year’s returns are likely to be on a par with those.

When considering the outlook for this year, the first point to appreciate is that Asia is still an attractive growth story. China’s economic slowdown being partly compensated by India’s pickup, Asia ex-Japan is still set to grow at 5.8% this year and next, according to the IMF’s forecasts. This stands in stark contrast to the outlook for other emerging markets, which are suffering from a mix of problems, including low commodity prices.

THIS YEAR’S EXPECTED total return from bonds depends on many moving parts. The first is, of course, the likely increase in the Fed funds rate and the medium-term Treasury yields. Economists hold different views on how much the Fed would raise the target rate. Some point to the persistently low inflation, others talk about falling unemployment, and some highlight the potential for global issues (including China) to slow the pace of rate increase. But overall, the Fed funds futures are currently pricing in a Fed funds rate of 0.6% for the year-end. That indicates the potential for medium-term Treasury yields to rise less than expected, perhaps by 50bp.

The second key element is the credit spreads. According to the JACI data, the average Asian bond at the end of 2015 traded at 293bp over swaps, broken down into 222bp for investment-grade and 596bp for non-investment-grade. These spreads are eight times the pre-crisis levels for investment-grade and over six times for non-investment-grade. Although one may argue that the pre-crisis levels reflected unjustified and unsustainable exuberance, the current levels are still higher than the post-2009 average spreads by about 25bp for investment-grade and 140bp for non-investment-grade.

Compared to the US credit markets too, Asian bond yields are still higher, by about 90bp for investment-grade and 50bp for high-yield.

In our view, the current spreads reflect neither a significant overvaluation, nor undervaluation. Consequently, they indicate the potential for the spreads at the year-end to stay close to their current levels, perhaps within 20bp.

The third determinant of returns is defaults. At a global level, high-yield default rates are likely to pick up: Moody’s expects the global high-yield default rate to reach 3.7% by November 2016, a level that is higher than the 3% for last year, but still lower than the longer-term average of 4.2%. In Asia, most of the defaults have been triggered by the crash in commodity prices and the economic slowdown in China. These factors are likely to keep Asia’s default rates elevated, but should not lead to a spike.

THE TECHNICAL FACTORS for Asian bonds are likely to be supportive this year. Already, many major issuers have turned to Chinese domestic bonds instead of US dollars, as it offers them cheaper funding and reduces their currency risk. This year’s supply of new bonds is also likely to be restrained by the same trends, particularly in the China high-yield sector.

At the same time, the demand for bonds has remained strong, in particular from the institutional investors in the region, who picked up 63% of new issues in 2015, up from 58% in each of the three years prior to that. For most investors, Asian bonds have become a mainstream asset class, rather than a frontier asset class; and they are likely to maintain their presence in Asian bond markets in the medium- to long-term.

Based on these factors, we expect Asian bonds to generate total returns of 2%-4% if five-year Treasury yields rise by 50bp. Even if the five-year rates rise by 75bp, which seems aggressive given the uncertainties surrounding further rate increases, Asian bonds can still generate positive returns in the range of 0.7%-3%.

Given the higher yields and lower duration, high-yield bonds on the whole are likely to generate higher returns than investment-grade bonds by about 200bp in the base case. However, the challenge for investors is likely to be one of avoiding the potential defaulters. That is no easy task, since the defaults are triggered not only by economic, but sometimes by political factors as well. Another challenge of investing in high-yield is the lower liquidity due to the shrinking capacity of banks to hold inventories and make markets.
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In an environment of so many uncertainties – including those around the Chinese economy, commodity prices and geopolitical risks – we believe investors should maintain a reasonable allocation to fixed income to provide stability to their portfolio returns.

This is the reproduction of a recent article in IFR Asia.

While the world’s attention was focused on Greece’s negotiations with its lenders, another crazy spectacle was unfolding on the other side of the world. After running up 150% in the 12 months to June 12, the Shanghai stock market plunged by nearly a third in the next month.

There had been no fundamental reasons for the exuberance. China’s economy had in fact been slowing, with GDP growth at 7% in the first two quarters, down from 7.4% for the last year. The property sector, an important contributor to the economy, had also been struggling, with both volumes and prices showing a marked slowdown. Corporate profitability had been squeezed and unofficial estimates of non-performing loans in the Chinese banking system had been rising. The central bank only started cutting rates in November 2014, by which time the rally was already in full swing.

On the contrary, the run-up had been related primarily to a significant flow of financing to the stock market through a variety of channels: margin financing, collateralized lending, shadow financing through trusts, and direct peer-to-peer lending. While the overall value of borrowed funds in the stock market is difficult to judge, some estimates put the value as high as a third of all floating shares.

This diversion of funds could be in part a result of cooling property markets. As the property markets began to cool, the private savings that had been invested in it through shadow-banking channels began to be diverted to lending against stocks, in search of returns in the high teens.

Retail investors got caught up in the frenzy in the late stages of the rally, helping push the markets even higher. According to reports, more than 80 million retail broking accounts were opened towards the end of the rally.

As the market crashed, there was panic all around. Listed firms chose to suspend trading on their shares (nearly 50% of the Shanghai index was suspended at one point), and investors tried to cash out. But regulators panicked too. They organised a coordinated rescue by injecting Rmb120bn, first tightening and then relaxing the rules for margin financing, stopping IPOs, and changing the rules for opening of trading accounts. The central bank also announced another cut in interest rates, and authorities are now looking for foreign funds that might have shorted the market (and have started suspending some trading accounts of foreign fund managers). The stock market then went through several days of further volatility, but the precipitous crash had been arrested.

WHAT IMPACT IS the recent stock volatility likely to leave in its wake – assuming that the worst is indeed over for now? First of all, there is no doubt that faith of the common man in the stock markets has again been shaken, making Chinese investors question the viability of the equity market as a repository for their savings, at least in the medium term.

What China needs in the long run is to develop the equity market as a stable avenue for financing for businesses, particularly private-sector companies and small and medium enterprises. At the end of 2014, China relied on bank credit to finance its private sector to the extent of 142% of GDP, far higher than the ratio of 50% in the US, according to the World Bank. Conversely, China’s stock market capitalization was only 44% of GDP versus 116% in the US in 2012, again on World Bank data.

This reliance on bank credit leads to distortions in the allocation of capital to the most profitable and deserving businesses. Developing domestic stock and bond markets is a key necessity in improving the efficiency of capital. This year’s stock volatility – and another IPO freeze – is a setback in that process.

The government’s actions have also given rise to a version of moral hazard. There is already a persistent belief in the bond markets that the government will rescue troubled companies, leading to mispricing of risk. Last month’s intervention has created a similar belief among equity investors.

Individual investors, who account for a large proportion of equity trading volumes in China, are only likely to have been left with a confused impression of equity as a method of savings.

FOREIGN INVESTORS HAVE also been caught in the maelstrom, with monthly net purchases of mainland stocks under the Shanghai-Hong Kong Stock Connect scheme turning negative in July for the first time since the scheme was launched last November. Investors also found that some of the eligible Chinese stocks had been suspended from trading. In fact, 10 of the SSE 180 index stocks, all of which are eligible for Stock Connect, were still frozen at the time of writing.

In the coming months, we will know if the crash has dented consumer confidence and retail sales, but it is still too early to see the impact on the real economy. For the property sector, on the other hand, the crash may turn out to be a blessing, since savers may turn back to buying property as their preferred saving method. Already, there are mounting signs of stability in the property market, and the stock crash may further help strengthen the sector.

In February this year, US academics published a paper for the National Bureau of Economic Research arguing that “China’s stock market no longer deserves its reputation as a casino”.

The authors measured the ability of market valuations to differentiate between firms that will have high profits in the future from those that will not, concluding that “the informativeness of stock prices about future corporate earnings [in China] has increased steadily, reaching levels that compare favourably with those in the US.”

Had they sought to measure the rationality of the overall market valuation (as opposed to the ability to differentiate between firms), I wonder if they might have reached a rather different conclusion.

This is the reproduction of an article published in IFR Asia.

The Modi government’s first budget for the year 2014–15 failed to seize the possibilities in front of it. India elected Narendra Modi last year largely on the hopes that he would deliver growth and jobs. Based on his track record in Gujarat of running an efficient, corruption-free government, everyone hoped that he would quickly deliver the reforms needed to power up India’s growth rate and deliver jobs to realize the demographic dividend and avert a demographic disaster.

Instead of concrete steps, backed up by real money, to address the problems that shackle India, the latest budget contains yet more plans and dreams of future action.

The budget has to be judged in two contexts. One is the historic opportunity facing the country, and the other is the urgent need for reform.

India faces a fortuitous situation of falling oil and commodity prices. Since India is a large importer of oil, the falling oil price would benefit it in many ways: it would contain the current account deficit, lower the fiscal deficit and temper inflation. In many ways, this frees up resources that can be invested in infrastructure and education to take the country to a higher level of sustainable growth.

But the government has not taken full advantage of this opportunity. Other than fuel, the budget has actually raised the subsidies for food and fertilizer. It even increased the allocation for the rural employment guarantee programme started by the previous government. Without cutting these expensive subsidies, the country is going to find it difficult to generate resources for investment. This failure to curb the subsidies is one of the most significant shortcomings of the budget.

The budget does plan to provide more funds for developmental expenditure – roads, railways and infrastructure – but only by assuming high GDP growth and tax collections. It assumes nominal GDP growth of 11.5%, which could translate to a real growth rate of 8% to 8.5%. Although the recent revision to the GDP growth calculation has pushed up reported growth to 7.4% in the last quarter, it remains doubtful whether growth can rise enough to match the budget’s assumptions. After all, everyone was forecasting a rate of about 6.5% not long ago. The expected tax revenue growth of 15.8% also looks problematic, coming after a more modest 9.9% for the last year. If the tax collection ultimately falls short, the government will find it difficult to fund all its promises and still restrict the fiscal deficit to the planned 3.9%.

TO ITS CREDIT, the budget contains several good ideas for the future. The planned reduction in corporate tax rate from 30% to 25%, while eliminating many of the tax exemptions, is a step in the right direction, but it will be done over four years. After several years of planning and discussion, the implementation of the national goods and services tax is targeted for April 2016, provided that legislation is agreed. The government has also announced plans to turn the gold holdings of Indians into monetary savings. It aims to improve the ease of doing business and reach a ranking within the top 50 from the current 142. It is considering establishing ‘plug and play’ infrastructure projects with all regulatory clearances and coal/gas links in place. It is planning a new bankruptcy law to deal with non-performing bank assets.

Another positive step announced in the budget is the agreement with the Reserve Bank of India to target inflation of 4% within a band of 2% to 6%. This is likely to bolster the independence of the central bank in setting monetary policy. Once the required legislation is passed, the government intends to set up a monetary policy committee rather than leave decisions to the central bank governor, although the danger is that the committee would be seriously compromised if it is stuffed with political appointees.

THE ISSUE IS that these ideas are all promises for the future. In the meantime, the government has failed to reallocate hard money from wasteful expenditure and subsidies to development. It is not clear if the government will have the luxury of low oil and commodity prices for the next few years. If oil prices start rising, India’s finances will again be squeezed, and these plans may never make it to reality.

The government has also postponed the target of bringing the fiscal deficit within 3% by one year – it now expects to achieve it by 2017–18. While a lower fiscal deficit need not be India’s sole focus, the achievement of that target also depends on oil prices remaining benign.

It is not easy to turn around a large democracy like India, and the Modi government deserves praise for thinking through some important ideas for the future. But it could have been so much bolder in reallocating resources from wasteful expenses to productive uses. After all, opportunity knocks but once.

In the past year, India has transformed from an ugly duckling to a beautiful swan with amazing speed. Little more than 12 months ago, foreign investors were busy pulling out of India on doubts about the country’s balance of payments position, sending the rupee and the stock market crashing, and bond spreads soaring. But today, India is on the buy list of every major equity and fixed-income investor worldwide.

There are two significant drivers for this turnaround. The first came when India managed to quell fears of a balance of payments crisis through a combination of import controls on gold, raising dollars from non-residents and demonstrating a commitment to contain its fiscal deficit. The second was May’s election of a pro-reform government led by Narendra Modi, which bolstered confidence that India would undertake fundamental structural reforms and turn itself around.

India is now on the cusp of a positive confluence of factors. Although economic growth has partly revived to 5.7% for the second quarter of 2014, it remains far below the highs of 9% seen in 2010. But inflation has fallen from 11.2% last November to 6.5% in September; hopes are high that this will soon allow the Reserve Bank of India to cut interest rates to trigger a pick-up in growth. The recent fall in global oil and gold prices is also fortuitous for India, as it will not only help lower inflation but also help eliminate the current-account deficit.

Structurally too, Modi is moving towards implementing important economic reforms; he has started with freeing the diesel prices and has moved to permit commercial coal mining; many of the infrastructure projects are moving ahead again; several small steps have been taken to ease the regulatory burden on businesses. However, many major reforms are still awaited, including implementation of a national goods and services tax, easier land acquisition, and relaxation of labor laws. Based largely on the expectation of further reforms, S&P changed the outlook on its BBB– rating from negative to stable.

Global investors have reacted positively. The Indian rupee has been the world’s best-performing emerging-market currency, staying flat during 2014 while the ruble has lost 30% and the Brazilian real 9%. The Indian stock market has risen 36% this year. Foreign portfolio inflows have picked up, reaching US$16bn in equities and US$24bn in domestic bonds.

In the Asian US dollar bond market too, Indian bonds have been among the best performers, rising 10.7% this year and outperforming the overall return of 8.1% for JP Morgan Asia Credit Index. The average credit spread on dollar bonds from India has compressed from 337bp at the beginning of the year to 249bp.

The key question for bond investors at this stage is whether Indian spreads can tighten further. To answer it, investors can compare Indian spreads with typical US spreads. At the height of the crisis last year, Indian spreads had widened to levels equivalent to Single B rated US bonds, on average. Since then, they have compressed back to levels somewhat tighter than Double B rated US bonds. (See Chart.) In fact, current average spreads for India are the tightest, relative to US bonds, in the last five years.

For all the positive attention that India is receiving from global investors, India makes up only 9% of the Asian US dollar bond market. While new issues from India this year have exceeded US$15bn, up from US$13bn for the whole of last year, dollar bonds remain a small segment relative to the size and potential of the Indian economy. Of the US$47bn of bonds outstanding, 50% are from Indian banks, which regularly access dollar bond markets to raise senior debt and subordinated capital. Another 8% has come from quasi-sovereign entities, and the rest from companies in different sectors. That again indicates the limited range of Indian issuers.

Part of the reason for India’s diminished share of Asia’s US dollar bond market lies in regulations on offshore borrowings. By specifying the maximum spreads that borrowers can pay for a given tenor (currently 500bp over Libor for over five years), the authorities have tried to encourage equity portfolio investments rather than debt. Besides, the Indian government itself has shied away from offshore commercial borrowings, and only 6% of the national debt is borrowed offshore. While this policy has protected India from the sudden loss of confidence of global lenders, it has also limited the amount of capital available for growth companies.

If India uses the tailwinds of falling oil and gold prices, stays resolute in its fight against inflation and implements difficult structural reforms, it will surely turn more global investors into enthusiastic supporters. Current credit spreads show fixed-income investors are already convinced. This is India’s time!

This is the reproduction of an article in IFR Asia.

Asian bonds have had a good run so far this year, producing a total return of 7.8% according to J.P. Morgan Asia Credit Index (JACI). But, looking back over the last three years, yields and spreads have steadily declined, so much so that “high yield” has become an oxymoron!

That has raised the question in the minds of many people: Is there a bubble in Asian fixed income?

The “B” word has been applied variously to different asset markets, such that it has become an amorphous thing … one that everyone talks about all the time, but no one knows precisely what it means!  Let us try to keep the dreaded word in perspective for our discussion. One definition of a bubble is when the prices are far in excess of the fundamental value of the assets. Another way to look at a bubble is as an unsustainable and fast rise in prices. Either way, a bubble carries the potential to hurt investors when it eventually suddenly bursts.

Keeping this in mind, let us examine the evidence in the Asian U.S. Dollar bond markets. The first evidence for the existence of a bubble is the contraction in both yields and spreads. It is true that the current yield to maturity of 4.6% for JACI seems too tight, particularly when compared with the high level of 11% during the Global Financial Crisis. But if we disregard the spike in yields during the GFC and the period when the interest rates were slashed in its aftermath, average yields have moved in a narrower range of 4.2% to 5.5% in the last four years and the current yield is near the middle of this range.

Similarly, if we consider the history of spreads, the current spreads over Treasury of 243bp appears tight when compared with the GFC high of over 800bp. But in the last four years, they have ranged between 214bp and 450bp; and if we disregard the mini-spike during the European sovereign crisis, they have moved between 214bp and 320bp. Compared to this range, the current spreads do not appear so alarming. In fact, they are more than double the tight levels of 109bp reached in 2007 before the GFC.

Compared to the U.S. domestic bonds, Asian spreads still offer value. Asian investment-grade corporate bonds, for example, trade at 180bp over Treasury, while spreads for U.S. industrial bonds with equivalent credit quality and maturity trade at spreads of 100bp.

When we consider the fundamentals, another key factor is the default rate for bonds. According to Moody’s, the global high-yield default rate was 2.1% for July 2014, well below the historical average of 4.7%. In Asia-Pacific, Moody’s predicts a default rate of 3.3%.

While such low default rates are one of the supports for the current tight spreads, we must remember that they are themselves partly the result of loose liquidity conditions and easy monetary policy. That brings us to the one of the key reasons to question whether the Asian bond market might collapse in a bubble-like fashion when rates start rising and liquidity begins to ebb. It is doubtless true that the bond valuations have benefited from the falling rates. In 2014 so far, of the 7.8% return generated by Asian bonds, 3.6% has come from a fall in Treasury yields and the rest from tightening spreads.

This comfortable environment would change as the Fed starts raising rates in the second half of 2015. Not only will longer-duration bonds face capital losses, but weaker companies would find it more challenging to roll over maturing debt – in turn leading to higher default rates.

It is based on such fears that some predicted a mass migration of funds from fixed income to equity, calling it the Great Rotation. But so far, in the Asian bond markets, there has been scant evidence of such a shift. New issue volumes are touching record levels, with USD 120 bn of new bonds so far this year, representing a growth of 35% over the same period last year. Although private banks have taken up only 9.7% of new issues this year, down from 16.2% and 13.9% in the last two years, the gap has been more than adequately filled by institutional funds.

At a very fundamental level, Asian economic growth is holding up reasonably well, although all eyes are on China’s and India’s growth rates to see how these two economies perform. For the Asian bond market, China is a key variable, particularly the Chinese property sector.

So, finally, is there a bubble or not in Asian bonds? Although Asian bond valuations are stretched at the moment, they are not beyond belief and entirely divorced from fundamental factors. Some of the supporting factors such as rates and high liquidity will diminish over the next two years, but I believe the correction would be orderly and not a sudden collapse. Asian bond valuations may be tight, but they are not a bubble.

One year ago, when Bernanke first mentioned the possibility of tapering, the asset markets took fright that the Fed would take away the punch bowl. The U.S. Treasury yields spiked immediately, leading many commentators to predict an Armageddon in the fixed-income markets resulting from a combination of rising rates, falling asset prices, shifting of funds to equity markets.

However, the reality so far has turned out to be very different. As the Fed began the actual tapering, interest rates have gone down this year. The 10-year Treasury yields ended the last year at 3%, but have since retreated to 2.6%, reflecting the hesitant performance of the U.S. economy as well as the additional monetary stimulus from Japan and the possibility of a stimulus from the ECB.

Neither has the “great rotation” out of fixed income into equities materialized. The equity funds covered by EPFR have received USD 46 bn of inflows this year, while the bond funds have gathered USD 84bn. It is interesting to note that both figures are lower than those recorded in the same period last year (USD 140 bn for equity and USD 100 bn for bonds). However, these figures mask a striking contrast between developed-market and emerging-market funds: the former gained USD 68 bn in equity and USD 90 bn in bonds, while the latter lost USD 23 bn in equity and USD 7 bn in bonds.

If one were to observe the Asian USD bonds, however, one would certainly believe that the good times are still rolling on. New bonds worth USD 80 bn have been issued in the first five months of 2014, at par with the corresponding period of last year. (Note that the chart below includes EUR and JPY as well).

Asian USD bonds have so far produced a total return of 5.6% (see table below), split roughly equally between the returns from the falling US Treasury yields and the tightening spreads. Split another way, coupons have generated about 2% so far, while rising bond prices (both due to US Treasury and spreads) have produced 3.4%. The table below shows that investment-grade has outperformed high-yield so far. This is mainly thanks to the concerns over the Chinese property credits and the impact of the falling coal prices on Indonesian mining credits. 

This total return looks quite respectable when viewed against the overall equity market performance. MSCI Asia ex-Japan equity index is up 2.8% this year, thanks mainly to emerging markets such as India. Hang Seng, on the other hand, is flat.

Regular readers of this blog may remember our recommendation for this year to overweight high-yield. We still expect high-yield to outperform investment grade. While we still believe in that prognosis, investors would be well advised to follow two other broad strategies:

• Stick to better quality names: While liquidity is still comfortable, there will come a day when companies with lower credit quality will find it difficult to refinance themselves. Already, bonds with lower ratings have underperformed: as the chart below shows, the best returns have come from “BBB” bonds, while the worst have come from “B” and “C” rated bonds.
  

• Control the duration: While the decline in the interest rates have taken many people by surprise, thereby enabling the longer-duration paper to do well, it is difficult to conceive of the rates falling further. In fact, discussions have already started in the Fed about when the first rate increase should take place. At this juncture, it is better to shorten the maturity of the portfolio towards five years rather than longer. Many perpetual bonds look increasingly riskier, unless the issuer has a strong incentive to call the bonds earlier.
  

Within Asia, the north-eastern countries (Japan, Korea and Taiwan) have progressed much faster in the last 50 years than the south-eastern countries (Indonesia, Philippines, Thailand and Malaysia).

Would you believe that, in 1950, Philippines was richer than Korea and Taiwan? Or that there was hardly any difference between Taiwan, Korea, Indonesia and Thailand? Or that China was lagging Indonesia and Philippines? Here are their GDP per capita figures for 1950: Japan $1,873, Philippines $1,293, Taiwan $922, Korea $876, Indonesia $874, Thailand $848, China $614, India $597*. Today, Japan, Korea and Taiwan have all ascended to the developed country status, while Indonesia, Philippines and Thailand have been left behind. The question is why.

In his latest book, "How Asia Works", Joe Studwell tries to answer that question. He identifies a magic formula with three ingredients: land reforms; state-supported manufacturing development; and state-controlled  financial sector being harnessed to support manufacturing.

The first one, land reforms, consists of restructuring agriculture  into labor-intensive household farming, which maximizes agricultural productivity by making use of the excess labor available in the initial stages of development. This results in a surplus that creates demand for goods and services and sets the stage for the second initiative, development of state-supported manufacturing.

State-supported manufacturing means channeling investment towards manufacturing rather than other types of businesses. This creates productive jobs for workers with limited skills as they migrate out of agriculture. For this process to be successful, Studwell lays down two essential conditions: rapid learning of advanced manufacturing technologies and subjecting manufacturing to export discipline to make sure that only the globally competitive industries survive.

The third intervention is to control and harness the financial sector to provide the necessary capital for the agricultural and manufacturing development, rather than other types of businesses, including services and personal consumption. The financial sector could also be used as a tool to ensure export discipline for the manufacturing industries.

Well, that's it - the magic formula. Having explained this right upfront in the foreword, Studwell spends the rest of the book mainly presenting the historical evidence for his theory. Much of his evidence is anecdotal and historical; not much of statistical tables and charts, but a lot of narrative economic history. In between, the narrative is interspersed with his observations from his travels in some of the countries, in so far as they are related to his theory.

In general economic commentaries, we do not generally read much about state-directed manufacturing and finance as elements critical to economic development. Hence Studwell’s theory is an interesting one. But I could not help questioning it as I read along.

One issue is whether these historical lessons are still relevant. In other words, can the lesser-developed countries start implementing this formula today and achieve development? For instance, it can be argued that what is holding back India are misdirected and wasted subsidies, corrupt and inefficient bureaucracy and the plutocratic political class. For India, the solution has to start with dismantling the current economic and political structures rather than more state-directed support for selected manufacturing industries or state-directed lending for farming and manufacturing.

In many places, the book comes across like extolling central planning and state control. Studwell praises the economic model followed by Park Chung-hee, Korean dictator from 1961 until his assassination in 1979. It so happened that Park’s economic policies contained some of the positive elements such as manufacturing development, rapid technological acquisition and development of globally competitive industries, which helped Korea’s fast economic development. But central planning and government control over the economy can easily turn into crony capitalism, as it happened in Indonesia’s Suharto period or in India until the economic liberalization of 1991. Russia is another ongoing example of how state control has not managed to lay the foundations for sustained economic performance – the country remains sorely dependent on oil and gas revenues. The point is that, for every one successful state-directed economic development, there are myriad examples of misdirected, corrupt and failed attempts of state-directed economy.

It is not clear to what extent Studwell’s model applies to China’s incredible rise in the last four decades. While China has followed the export-led growth model and turned itself into the world’s factory, it has yet to prove its ability to acquire and develop advanced technologies. Although Studwell provides some figures about the growth in the total profits earned by state-owned firms, there is a lot of other evidence that their return on capital invested is much lower than that achieved by private firms. It is then no wonder that China's incremental capital-output ratio has been rising. China today stands at a crossroads, when it needs to shift from export-and-investment-led growth to domestic-and-consumption-led growth.

A good question may be worth more than one good answer. As such, books should not be judged solely by their ability to provide answers. In that sense, Studwell’s book provokes many interesting questions. For example, how is India going to achieve economic prosperity and provide jobs to its expanding young population without developing its manufacturing sector? Its vaunted information technology sector has created 3m direct jobs, hardly enough to scratch the surface, leave alone making a dent in the country’s employment levels. While Indonesia has ridden the commodity boom for the last 10 years, how is it going to climb further without a coherent competitive strategy? Malaysia has got stuck in the middle-income trap without a clear strategy of how to develop further.

As Studwell points out, the economic profession seems to have adopted the mantra of free market, the government’s role being only to build the infrastructure, provide the legal and institutional framework and set the monetary policy, leaving the manufacturing and services sectors to decide their growth strategies. This book raises interesting questions about whether
governments should legitimately play a more interventionist role in fostering development.

I had immensely enjoyed Studwell’s earlier book, “Asian Godfathers”. It was a riot of a read about Asia’s business tycoons and their escapades, although with a solid message about how they had cornered the economic systems to their own advantage. “How Asia Works”, on the other hand, is much more of a slow and difficult read.

* "All countries compared for Economy> GDP per capita in 1950, Angus Maddison. Aggregates compiled by NationMaster." 1950. 
< http://www.nationmaster.com/country-info/stats/Economy/GDP-per-capita-in-1950>.

This is a reproduction of an article in Reuters.

Ever since reports emerged that the United States might taper off its bond-buying program, emerging markets have whipsawed: falling currencies, rising rates and fleeing funds. India and Indonesia have been two of the most affected countries in Asia.

The Asian dollar bond markets have also been affected by the fear of tapering. On the one side, longer-term bonds have lost substantial value as U.S. interest rates have picked up. Additionally, investors have discriminated between bonds from vulnerable countries and those from stronger countries.

In India’s case, state-linked entities such as banks and oil companies have issued most of the bonds. Since May 22, when the word “tapering” burst into financial markets, the Indian rupee has plunged by 23 percent. At the same time, spreads for Indian dollar bonds widened by as much as 130 basis points, even for five-year bonds. The spreads on the benchmark 2018 bond from State Bank of India widened by 120 basis points from end-May until end-August.

There were many underlying fears that led to this. One was a potential downgrade of India’s rating, currently at its lowest investment-grade level. Standard & Poor’s, in particular, has a negative outlook on its rating, and has remarked that there is a one-third chance of a downgrade in the next one to two years, which may well be accelerated if things do not improve. The other fears are rising inflation, a slowdown in growth and the consequent deterioration of business fundamentals.

For Indonesia, the currency depreciation during the same period was 16 percent; but the 2018 and 2023 Indonesian sovereign dollar bond spreads widened by 140-150 basis points. This is despite the fact that Indonesia took some strong steps to control the situation, including raising petrol prices by 44 percent and diesel prices by 22 percent in June, and raising interest rates by 125 basis points.

During the same period, the spreads on dollar bonds issued from stronger countries have hardly widened. For instance, from Hong Kong, Hutchison’s 2019 bond spreads are up by only 10 basis points; from Singapore, Temasek’s 2023 bond’s spreads have not changed; from Korea, the 2019 sovereign bond’s spreads have risen by only 5 basis points.

Chinese dollar bonds present a different story. Their performance has been driven more by evolving views on Chinese growth, rather than U.S. Fed tapering fears. While bonds from cyclical sectors, such as Cement and Steel, have widened by 50-150 basis points, those from property companies have held well (for instance, the benchmark Country Garden 2018 bond has actually compressed by 40 basis points in terms of spreads).

The overall picture in the Asian dollar bond market, then, is one of rising discrimination between bonds from weaker and stronger economies. Similarly, even within the same country, bonds that are more vulnerable to economic slowdown have underperformed. For instance, in India, bonds issued by private-sector banks and companies have outperformed those from state-linked banks and companies.

In a way, this is a testament to the market’s ability to distinguish specific kinds of credit in  terms of their strengths and weaknesses, rather than lumping all of them into an “emerging market” bucket.

As we look ahead, one key question is whether potential tapering has been fully priced in to the Asian bond markets. While U.S. 10-year rates have gone up by more than 120 basis points, many emerging-market currencies and equities have slid, and bond spreads have risen, there is still likely to be a residual effect which will kick in once the tapering plans are confirmed and the actual tapering begins. When that happens, the discrimination between credits in Asia will only strengthen.

In that sense, India and Indonesia cannot rest easy yet. Their struggles with currency, inflation and their balance of payments are likely to spill over into their dollar bonds too, taking their spreads higher as and when tapering begins in  earnest.

At some point, though, some investors will find value in these bonds. There is some evidence that Indian spreads reflect about 60 to 70 percent of the impact of a rating downgrade. If that number inches towards 80 to 90 percent, that would be a good time to buy those bonds.