It’s Asian Bonds, Not Equities, That Are Too Rich

An unusual parallel rally in Asian bonds and equities, powered for the last five years by cheap global funds, could give out soon with debt becoming a casualty of the increasing confidence in the outlook for global growth.

Bonds are now pricing in an extremely bleak economic outlook, making them susceptible to any spike in long-term rates. The rise in equities has been less pronounced, leaving room for further gains as a pick up in global demand boosts corporate earnings.

The tricky part for investors, however, is to precisely time their exit from bonds. Strictly speaking, bonds can continue to feed off the supply of cheap money from central banks in developed markets. Plus, there is the nagging risk of a hard landing in China and escalating crises in Iraq and Ukraine, which could push investors back into the safety of fixed-income assets.

“It’s a bubble in caution,” said Markus Rosgen, Asian equity strategist at Citi.

“The bond market is too bearish on the outlook for growth, and people will say if growth is improving, then I have a claim on growth through equities which I don’t through bonds, then I ought to switch out of bonds into equities.”

“So it’s generally equity-friendlier than it is bond-friendlier,” said Rosgen.

Investment bank analysts warn bond levels are frothy and there are traces of a shift of retail money from bond funds to equity. But the actual decision to sell bonds is complicated by powerful but divergent catalysts.

The Federal Reserve is reducing its bond purchases, but appears in no rush to raise interest rates. European authorities are easing policy. Britain has hinted at early rate rises. A handful of Asian central banks, including in New Zealand and the Philippines, are raising rates.

The growth picture is changing, with Japan, the United States and even parts of Europe showing improvements in demand, although analysts now expect 2014 to be less robust than they did before.

That means the long end of the U.S. Treasuries yield curve may stay lower for longer and so preclude a rise in global yields.

That would leave fund managers at risk of underperforming global bond indexes if they sold bonds prematurely.

CARRY TRADE BUBBLE

As things stand, however, there is not much value in bonds, particularly not for carry traders who borrow cheap short-term funds and seek to exploit interest rate differentials.

Even in markets offering nominal yields above 8 percent on bonds, namely India and Indonesia, returns have shrunk. Foreigners raising money in the offshore rupee swap market and buying a 10-year Indian government bond would make just 150 basis points (bps) or so, less than a third of what they made in 2011.

In Indonesia, it is merely 220 bps, and in other markets such as South Korea and the Philippines it is less than 70 bps.

It is trickier to spot a top in credit markets as the composition of benchmark bond indexes changes frequently, but even JPMorgan’s emerging market Asian credit index is trading at a spread of 241 bps over comparable U.S. Treasuries, the narrowest in almost three years.

“The carry that we are getting in markets like Malaysia and Korea, which are relatively lower-yielding markets, is not attractive and not offsetting the duration risk we are holding,” said Prashant Singh, lead portfolio manager at Neuberger Berman in Singapore. The fund has $247 billion under management globally, of which $101 billion is in fixed income.

Equities, in comparison, have seen pockets of exuberance, such as in India and the Philippines. But the Asia MSCI index is up just 14 percent since October 2011.

Both the price-to-book ratio and price-to-earnings ratio for Asia, key measures of relative value, remain well below historic averages and are far from the peaks hit during the 1997 Asian financial crisis and the 2007 global crisis.

The region is cheap versus global equity markets, with the potential to outperform as company earnings improve, said Citi’s Rosgen.

Simon Derrick, head of the markets strategy team at BNY Mellon, worries about the bubble-like values in Asian bond markets. BNY Mellon has $1.6 trillion under management and is custodian to a further $27.9 trillion of assets.

“I am starting to think that this is looking like quite a mature rally and certain markets are starting to look a little tired,” said Derrick. “But it is impossible to say when it will peak out.”

“The carry trade worries me a lot because there are echoes of 1996-1998 and of 2005-2007,” he said. “But that does not mean it will be a repeat.”