Our previous article explored how the Asian bond markets – specifically the local-currency space – have matured, becoming an asset class of its own as a new global core. This month, we make a case for why we believe Asian local currency fixed income remains a valuable addition to a portfolio, even amid uncertainty around the global Covid-19 pandemic and geopolitical tensions.
Favourable risk-return profile
With the Covid-19 pandemic causing an increase in uncertainty and sparking a ‘flight to safety’, global investors are understandably wary about shouldering additional credit risk from emerging markets (EM). This is despite the contrast between the potential yield pick-up available in the EM space and the lack of return – especially in the developed market world – amid a persistent ‘lower for longer’ yield environment.
Although the pandemic has undoubtedly hit the corporate credit space, Asian government and quasi-government credits have been able to prevent their fundamentals from significantly weakening. Although governments will have to come up with additional funding for stimulus packages and supplementary budgets, many have alternative means of financing such packages – meaning they do not have to rely on the bond markets exclusively.
As such, the macro fundamentals of many Asian governments remain robust, and they will likely continue to be a growth driver as the global economy recovers. Investors, therefore, have an opportunity to obtain a good yield pick-up without taking on excessive risk.
In fact, Asian bonds have historically demonstrated a risk-return profile that is proportional to that of US Treasuries. This contrasts with many other non-Asian EM governments, where the step-up in potential return may not be fully justified when compared with the additional risk taken.
Potential for additional yield via local currency appreciation
There is a persistent stereotype when it comes to EM local currency bonds that most of the historical gains were derived from local currency appreciation. This might have led to some investors staying away, fearing currency volatility.
However, our analysis reveals that for Asian local currency bonds, currency appreciation only accounted for about a third of total returns. The remainder – and majority– of the returns were the result of the growth potential and macro fundamentals of the economies.
Nonetheless, we expect currency appreciation to continue to be an important source of
potential returns moving forward. Current US dollar strength has depressed currency gains in
Asian local currency bonds, but there is a good chance of a rebound over the medium to long term. In the meantime, US dollar strength presents attractive entry opportunities for Asian local currency bonds.
A ‘back to basics’ diversified portfolio construction strategy
Heightened uncertainty in markets will likely persist for some time. As a result, it makes sense for investors to take a defensive, ‘back to basics’ approach to portfolio construction. This does not entail a universal ‘flight to safety’ – but instead focuses on creating a well-diversified portfolio that offers an optimal risk-return profile.
In an increasingly interconnected world, correlations between Asian local currency bonds and other major asset classes have inevitably risen. Still, they remain low enough to allow such assets to add valuable diversification benefits to investors’ portfolios.
Investing in Asian local currency bonds
There is a belief that EMs are less efficient, therefore active strategies must be the optimal way forward. Yet the evidence tells a different story: even in so-called less efficient EMs, most active managers underperform their benchmarks.
According to Morningstar, as at end-2019, 57% of the 30 largest EM local currency debt funds benchmarked to the JPM GBI-EM Global Diversified Index underperformed the index over the past year1.
This ‘active underperformance’ phenomenon is even more apparent over a longer horizon, with 73% of them underperforming over three-year and five-year periods1.
Risks within EMs can be asymmetric and concentrated, making it extremely difficult to outperform benchmarks. The data thus suggests that index funds may be an optimal alternative for gaining exposure to Asian local currency bonds.
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1 Source: Morningstar, as of December 2019. 30 largest funds in the Morningstar's emerging market local currency debt category benchmarked to the JPM GBI-EM Global Diversified Index.
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