With bond yields at historical lows and the risk-free status of many developed countries under question, many investors are looking to diversify the income stream in the defensive part of their strategies. So why are Asian ex Japan bonds typically so underrepresented in fixed-income portfolios?
Asian bonds offer attractive yields: an average of 3.77% compared with a 0.70% average for five-year US, Japanese and German bonds. Furthermore, Asian bonds score relatively high in terms of creditworthiness thanks to the strong fundamentals of many Asian countries, which include robust economic growth and large foreign reserves. Corporate issuers in the region generally have stronger balance sheets than their global counterparts. And lastly, Asian bonds offer exposure to local currencies that look set to appreciate in the longer term as growth and productivity in the region continue to outpace the developed world.
Asia still falls into the emerging-market category, but we believe that the region’s strong economic performance over the past 10 years deserves consideration in its own right. Emerging markets today make up almost half of the global economy, and the bulk of the growth in that share over the past decade has come from Asia.
When it comes to the bond markets, however, Asia still makes up a relatively thin slice of the global pie. It is capitalized at about $2.4 trillion, compared with some $40 trillion for the global bond market. As a result, Asian debt makes up just a tiny sliver of global benchmarks such as the Barclays Capital Global Aggregate Index, and a relatively modest slice of the J.P. Morgan Emerging Market Bond Index (EMBI), the most popular benchmark for emerging-market debt (Display).
The reason for this underrepresentation is that nearly all bond indices are market-cap weighted. This means that the companies or governments with the greatest weights in bond indices—and the portfolios of investors tracking them—are those that issue the most debt (see The Tyranny of Bond Benchmarks for more information). In contrast, fiscally responsible sovereigns that issue less debt end up having a much smaller weight in the index. Since many Asian countries fall into the latter category, and many bond investors remain shackled to benchmarks, Asian bonds are getting short shrift.
So what’s the best way to access the opportunity? First, we’d recommend investors untether themselves from their benchmarks.
Instead, we think a sensible approach is to invest in the broader universe of Asian bonds and hedge the returns into renminbi. This way, investors can capture an attractive, diversified income stream, while reaping the long-term benefits of exposure to the Chinese currency.
Of course, there are challenges involved in investing in Asia. The region is culturally diverse; it contains many legal jurisdictions, and traditionally, liquidity has been poor. Investment managers need to have an understanding of these complexities, as well as cross-border operations expertise.
Second, as I have written before, it’s important to be aware of the structural features in developing segments of the market—for example, cases where there are supply and demand imbalances. We recommend taking a cautious approach to the so-called “dim sum market”—bonds denominated in renminbi but issued outside of mainland China—which has seen an explosion of issuance over the past year.
As the number of risk-free assets in the world continues to shrink, the strong fundamentals of many Asian countries make their bonds an attractive diversifier for fixed-income portfolios. We think Asia ex Japan’s growing prominence in the global economy—led by China—is set to continue in the long term. The only question is how long it will take investors to jump on board.
Hayden Briscoe is Director of Asia Pacific Fixed Income at AllianceBernstein
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.