Wednesday, 19 December 2018

Going local

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Borrowers facing a slowdown in bank credit and investors – including a growing middle class – looking for diversification should propel further growth in Asia’s local currency bond markets

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The diminished supply of cross-border credit in the aftermath of the financial crisis has led Asian corporates to rely more and more on domestic capital markets financing for their funding needs. In the past year, an increasing number of Asian issuers have been raising debt in either their own local markets, or in markets like Singapore, which is increasingly becoming a regional hub.

To the extent that regulatory changes in the West will continue to impede the availability of external financing – bank loans in particular – this is a positive development and one that Asian experts believe has great long-term potential.

“For an Asian company that’s funding its domestic operations, local currency bonds can be cheaper and safer,” says Rajeev De Mello, head of Asian fixed income for Schroders in Singapore, which in July, launched a new fund specifically to invest in Asian local currency bonds. “Yield curves in Asian countries are very low and investors increasingly have an appetite for local currency bonds. From the issuers’ perspective, there is no currency risk in raising money in their own unit of account.”

Clearly, Asian companies can benefit greatly by reducing their dependence on bank loans, cross-border as well as domestic. But every Asian country is at a different point in the development of lending and credit cultures and the pace of regulation and sovereign support at the country level will determine the extent to which local currency bond market financing will or will not pick up steam going forward.

The balance between bank loans and capital markets instruments at the local level varies greatly from country to country in Asia, said Ousmene Mandeng, co-head of the public sector group at UBS in London.

“In general, I’d say that Asia is starting from a relatively low point on average compared with other countries, including other emerging markets, with respect to the use of the securities markets by companies, and even though domestic securities are increasing again in number, they remain small as a percentage of GDP,” Mandeng said.

Too short

Domestic corporate debt outstanding in emerging Asia represents on average about 24% of GDP compared with 58% in advanced economies, he says, not least because corporates in Asia and other emerging markets can issue longer tenors in foreign currency instruments, “so many are still tempted by that market”.

There is no denying that the international market still has great appeal for many Asia issuers, largely because the domestic markets are much smaller and have less depth. Issuers with larger needs, such as banks that finance the international businesses of multinational companies based in Asia, would definitely prefer the international markets, De Mello says. And although some of the more sophisticated issuers do hedge their currency risk, hedging products have become more expensive because of new regulation on derivatives, he says, which is another reason why the US dollar market may be more attractive to many issuers.

Furthermore, “local bond markets in Asia are still not very liquid and investors have to pay a significant bid-offer spread to trade a bond, which forces them to take an investment horizon closer to the remaining maturity of a bond issue to minimize trading costs,” De Mello said. “In many countries, taxes on corporate coupons are a disincentive for investors to participate in the local corporate bond markets as it reduces their after-tax returns. Many countries also offer favorable tax treatment to government bond investors, thereby making corporate bonds relatively less attractive.”

Nevertheless, the local markets in Asia are certainly developing and growing, aided by the weakness in the US dollar and the deterioration in US government finances, both of which are pushing investors to look for bond diversification across the globe.

Sovereign help

Experts like Mandeng believe that Asian sovereigns can help a great deal in encouraging that growth and fostering the right kind of environment for developing local currency bond markets, in particular by promoting the development of a yield curve that corporates can then use as a benchmark.

This has been happening in countries like the Philippines and Malaysia, where local currency sovereign bonds now have 30-year tenors.

“Twenty years ago, it would have been difficult to issue any paper with a tenor longer than 10 years in the Philippines,” says Teresa Kong, manager of Matthews International Capital Management’s Asia Strategic Income Fund. “But now, there’s quite a bit of a demand for longer-dated paper from local investors, and this is only set to continue as the middle class in many Asian countries continues to grow.”

Rise of the middle-class

Indeed, the growth of the middle class is probably the single most important factor in what Kong believes is a “one-way trend” with respect to local bond market development in Asia. As income levels continue to rise in many Asia countries, people’s lifestyles are changing and there’s an increasing need for consumer loans. And across Asia, the demand for products like mortgages and life insurance is also increasing, she says, and that means that banks, pension funds and life insurance companies need to invest in longer-dated paper in order to keep pace.

High net-worth individuals in Asia are also playing a big role in fostering local bond market development, Kong says, and they’re particularly important in supporting a market like Singapore, which a growing number of Asian issuers are increasingly turning to as an alternative to the US dollar market.

Whereas in the past high net-worth individuals in Asia would prefer to keep their money in hard currency, there is now a noticeable move to favour local currency investments. And this has allowed borrowers to refinance US dollar debt in Singapore dollars. Global Logistics Properties, whose longest bond outstanding is denominated in Singapore dollars, and Hong Kong developer Shui On both did exactly that recently.

“Of course, high net-worth individuals are looking for ‘brand name’ companies that they don’t need to do due diligence on, but their interest in buying Singapore dollar-denominated bonds and tucking them into the portfolios means that more companies are encouraged to issue in Singapore dollars rather than US dollars,” Kong says. “In Singapore particularly, there’s a real appetite for longer duration assets from high net-worth individuals, and that’s where some companies like GLP can even issue perpetuals.”

Wot? No index?

But local investors, no matter how deep their pockets may be, are not enough for the continued development of the local currency bond markets in Asia. According to Mandeng, foreign investment is also key to growth, and the fact that as yet there isn’t a major local currency corporate debt index for Asia is a big deterrent for foreign investors. As much as regulation in individual countries is important, and to the extent that local banks are encouraged or discouraged to hold corporate debt, “foreign investors play an important role and must be encouraged to play a role in local debt markets,” he says.

Overall, in an environment of very low growth in the US, Europe and Japan, Asian countries are certainly attractive to foreign investors as a result of their high growth rates and higher yields. And whereas the US, Europe and Japan would like to see their currencies weaken to help their economies recover, Asian economies can handle a gradual appreciation of their currencies, De Mello says, and this in turn will help investors in Asian local currency bonds.

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