While investors are struggling with extremely low global bond yields, Asian local currency bonds still offer considerable return potential, according to David Cheng of Schroders.
According to David Cheng, Investment Director Fixed Income at Schroders, it has rarely been as difficult to generate returns as it is today. What has been a key feature of markets since the introduction of quantitative easing after the 2008 global financial crisis has been reinforced by further measures in response to Covid-19, he said. About a quarter of the global bond market has a yield below zero, and many are close to zero, such as corporate bonds. One part of the market that still offers attractive returns is the Asian local currency bond market, he said."
What makes the Asian market so unique
One is Asia's strong economic fundamentals: emerging Asia has grown significantly faster than the rest of the world over the past 20 years and now contributes more than half of global GDP. Asia excluding Japan is the only region that has seen growth in 2020, largely due to China and Taiwan, the expert said.
Asian countries' government debt to GDP ratios are low and stable, with many countries' external debt close to zero, he said. Asian economies are less vulnerable to the volatility of global capital flows and benefit from large domestic savings deposits, according to David Cheng.
Second, it is the attractive bond valuations that make the Asian market unique: Despite better fundamentals, Asian bonds trade near historical averages or the cheap side of valuation levels compared to global developed market bonds, according to fixed income expert. The Asian total return of 3.3% compares to 0.8% for the U.S. Treasury Index and a value just above zero for global government bonds.
"China is a key region of the Asian local currency government bond market and a key factor in its attractive valuation. As China's economy recovers, the People's Bank of China has begun to normalize monetary policy again. The People's Bank of China's response to the crisis was also relatively measured and targeted, while the rest of the world implemented further large-scale quantitative easing and other measures", according to the expert.
Chinese government bond yields rose as the economy recovered, according to Cheng 2020. With inflationary pressures low and areas of the economy still in need of monetary policy support, he does not expect the People's Bank of China to move to a restrictive stance soon.
Another positive feature, according to David Cheng, is the wide range of opportunities offered by Asian local currency bonds. When Asian countries are categorized into developed, middle-income and emerging markets, the table below shows the various correlations to global equity and bond markets in these categories.
Bond markets in developed Asia, such as Singapore, South Korea, Hong Kong and Taiwan, tend to have lower yields and behave most like global developed government bond markets with negative correlations to equities. Middle-income countries led by China, including Malaysia and Thailand, tend to have lower correlations with other asset classes, according to the table.
"Emerging market bonds are high-yielding and more sensitive to global growth, less correlated with developed market government bonds and more correlated with risk assets. They tend to offer higher returns during economic recoveries. Overall, this results in a wide range of potential investment opportunities and diversification benefits", says David Cheng. "This creates room to profit from specific risks, separating investment decisions by interest rates and currencies", HE ADDED.
US dollar in downtrend
In addition, the fixed income expert sees significant upside potential in Asian currencies, an area of opportunity right now. There is a good possibility that the U.S. dollar is in a long-term downtrend due to the rising twin deficits, fiscal stimulus at record levels, zero interest rates and open-ended quantitative easing.
Historically, rising U.S. twin deficits in current account and fiscal balance have coincided with weakness in the U.S. dollar. Since reaching a cycle high in March during the "flight to quality," the U.S. dollar has declined by more than 10%. Emerging Asian currencies have benefited as a result. David Cheng believes that continued accommodative monetary policy, as well as additional significant fiscal support from the Biden administration, could put further pressure on the U.S. dollar.
"When we compare fiscal and current account balances, we see that Asian economies are in a strong position compared to the U.S. and other countries. Fiscal spending by Asian governments is relatively restrained. More effective containment of Covid-19 has made this possible, and at the same time these countries are less affected by commodity price volatility", says the expert. Asian economies are also benefiting from improving manufacturing activity and increased trade, in his view.
The ingredient for yield and diversification in the portfolio
David Cheng sees a positive outlook for Asian government bonds with continued positive yields, attractive yields and moderate volatility compared to other emerging markets and some global bond sectors. "Asian local currency bonds are supported by generally positive fundamentals, moderate growth, moderate inflation and stable finances, as well as a number of country and market-level characteristics", he argues.
He expects the share and importance of Asian economies and capital markets to continue to grow in the coming years. Local currency Asian bonds appear to be an area of the bond market that still has the potential to generate attractive yield returns in today's low interest rate environment, he said.