Although Asia’s debt markets have enjoyed rapid development, it’s too soon to say they have ‘come of age’, argues Dominique Jooris, managing director and head of investment-grade capital markets for Asia ex-Japan at Goldman Sachs.
Speaking yesterday at AsianInvestor and FinanceAsia’s second annual Asia-Pacific Debt Investor Forum in Hong Kong, Jooris says the market has enjoyed incredible growth since the 2008 global financial crisis.
The market has grown from $549 billion in 2008 to $1.14 trillion by the end of 2010, and remains on a trajectory of 44% compound annual growth in terms of issuance.
Credit ratings are reflecting how desirable this issuance looks to many investors. Since 2008, Moody’s Investors Service and Standard & Poor’s have downgraded Greece, Portugal, Ireland, Spain and Cyprus (Greece has fallen from A1/A to junk status), and upgraded China, Hong Kong, India, Philippines and South Korea. This is raising many questions about whether the very concept of ‘emerging markets’ holds true, and how to price Asian debentures.
Whatever the terminology, Jooris says this exciting story must be weighed by other realities that continue to set Asian bond markets apart from those in Europe and North America.
The majority of this Asia-Pac growth is renminbi-denominated debt, which accounted for $846 billion of that $1.14 trillion outstanding in 2010. This China tilt is partly a reflection of domestic policies by Beijing to limit bank lending: administrative measures to curb bank loans mean banks are increasingly turning to bond issuance as a quasi substitute.
However, these debentures are not fully traded or marketed, and they are mainly domestic, so they are off limits to international investors. Jooris notes markets such as South Korea provide investors with a more investable selection, with regular issuance that is documented and formatted to G3 standards.
Looking at the Asia-Pac market, local-currency issuance has soared, but bonds issued in G3 denominations (dollar, euro, sterling) continue to represent a small but stable slice of the pie.
In particular, credit is becoming a bigger part of the G3 Asian paper: in 2010, investment-grade issuance hit $22.4 billion, and high yield another $28.8 billion; moreover, issuance came from across the region, providing investors with a nicely diversified selection of securities.
But this progress must be put in context, as combined spread product issuance is only 5% of the amount issued from Europe last year. In fact, total Asia ex-Japan debt issuance in G3 currency (ie, most accessible to international investors), including sovereign and spread products, totalled $89 billion in 2010, which is a far cry from Europe’s $1.65 trillion of new issuance. The Asia portion would be far greater if you include renminbi-denominated debt, but this is irrelevant to international investors because they cannot access it.
There are some other important differences: Asian banks and insurance companies are not major issuers, while European ones are; and Asian durations tend to be longer term, aimed at buy-and-hold investors, while European borrowers issue far more bonds with maturities of five years or less. What this amounts to is a far less vibrant secondary market for Asian debt.
Jooris notes many investors express a desire to buy Asian bonds as a play on appreciating currencies. However, the lack of liquidity in secondary markets, as well as capital controls, mean Asian bonds often cannot play that role very effectively. For example, the lack of developed swaps markets means converting a local-currency bond into US dollars is so costly that it wipes out much of the FX gain.
Yields are another challenge: for international investors who are analysing securities on a value basis, rather than to buy and hold, prices on many Asian bonds have become too high. This is particularly true for the nascent offshore RMB market in Hong Kong. Although the market is expanding at a decent clip, it is difficult (because of structural issues around the use of proceeds) for many investment-grade borrowers to tap the market at sufficiently low yields to entice investors.
Although the CNH market adds a new plank to the Asian debt platform, the market is still missing some important pieces.
Asia bonds have diversified in many directions, and now include: currency-linked bonds, corporate hybrids, local-currency bonds formatted to comply with US Regulation-S and 144a formats (available for sale by US investors in public and private structures), high yield, investment grade, long maturities (out to 30 years), and new government issues that are enhancing local yield curves.
But Asia bond markets do not yet include covered bonds or asset-backed securities (notably mortgage-backed securities), and issuance from insurance companies and commercial banks remains limited.
These gaps have an impact on liquidity, says Jooris’ colleague, Julian Trott, managing director and head of debt syndicate for Asia ex-Japan at Goldman. He looks at credit-default swap spreads, and finds that, post-GFC, those on Asian high-yield bonds correlate tightly with those from Europe. That is a new and welcome development.
Trott argues that it is the G3 high-yield space that has attracted the most international investor demand, and therefore led to the convergence of Asian markets with global ones – a phenomenon now extending to investment grade and ultimately to sovereign markets.
However, the lack of liquidity in the swaps market for Asian CDS is holding the region back. He notes in Korea, 116 basis points on a five-year swap into US dollars is incredibly expensive. So while a Korean bond looks attractive for its yield and its currency appreciation, there are structural ‘gates’ impeding the efficient conversion in and out of dollars and won. The same is true across the region.
This means that those tight CDS correlations may not be a true measure of liquidity in Asian debt.
Moreover, CDS issuance may have risen at a healthy pace, but again, as with nominal bond outstandings, it is still far below what it should be were the markets fully developed. To wit: there is $20.5 billion of outstanding CDS issued against French sovereign debt last year, versus only $6.1 billion against China. China’s is the most actively traded Asian CDS market. Given China’s economy is so much larger than France’s, not to mention its huge banking sector, this lack of CDS is evidence that the tradable bond market is limited.
Similarly, Trott believes Asian CDS spreads overestimate the degree of liquidity actually present in the market: these spreads are meant to serve as a volatility gauge, but secondary markets in Asian bonds are pretty quiet, at least in some sectors. Local institutions hold these on a cash basis, not a spread basis – ie, they don’t trade them.
Asian markets need to see the emergence of much bigger and more sophisticated institutional investors, notably insurance companies and local fund-management shops, in order to boost the size of these markets relative to GDP.
Other factors that impede liquidity and the growth of bond markets include: a patchwork of withholding tax regimes; the lack of transparent, liquid pricing of currency swaps; uneven pricing mechanisms in local-currency markets, which sees borrowers get much more favourable pricing than they would enjoy from international creditors; and too little issuance of short-duration instruments from Asian financial institutions.
Jooris and Trott believe all of these impediments to liquid, smoothly functioning bond markets will evolve in the right direction. Jooris notes that it is unlikely investors will wake up one morning and declare that Asian bond markets have come of age, as all of these issues will be resolved gradually. There is a lot of work left for local regulators, government and corporate borrowers, institutional investors, and local and international fund managers.