With US QE¹ tapering having begun in January, it is inevitable that US Treasury yields will track higher over the course of 2014. However, the reverse could happen should US growth momentum stall or reverse. Barring such an exception, we expect the yield on 10-year US Treasuries to stabilize between 2.75 per cent and 3.5 per cent, with no change to the US fed funds rate for 2014.
With this backdrop, Asian rates will likely be biased higher over 2014 (see chart 1), but given that we have already seen a sizeable adjustment to yields in 2013, we expect the magnitude will be lower this year if our central scenario holds and inflation remains contained.
Rising yields do not necessarily imply negative total returns for Asian fixed income. In fact, looking at historical data, Asian local-currency bonds have produced strong, positive returns even during periods of sharply rising interest rates (see chart 2; returns were negative during the most recent period).
The ability to produce positive returns in a rising-rate environment has been due to a few factors. First, Asian fixed income has historically offered attractive yield carry, which helps mitigate the impact of capital losses from rising yields. Second, Asian currencies can provide an additional source of return to offset capital losses. Third, the wide diversity of Asian economies, often at different stages of the economic cycle, means that fundamentally driven managers can add value from country selection.
In 2013, the Philippines’ economy was a clear example. Despite the global rising yield environment, Philippine government bonds returned 5.2 per cent over the year in local-currency terms, supported by strong fundamentals that resulted in the sovereign credit-rating upgrade from high yield to investment grade by the three major international credit-rating agencies: S&P, Moody’s and Fitch.
Since its creation in December 2000, with the exception of 2013, the HSBC Asian Local Bond Index has generated a positive return every year since 2001, supported by various contributions from the factors outlined above – yield carry, currency appreciation, capital gains and diversification. Last year was the first year in the history of the index in which a negative return was generated, due to the dual impact of sharply rising yields and broad Asian currency depreciation, which offset selective country gains (e.g., the Philippines, Korea and offshore RMB bonds).
Looking ahead, while the environment could likely be challenging for Asian bonds, prospects should improve once we see a stabilization of US Treasury yields. With the adjustment in yields since May 2013, valuations are now looking more attractive in a number of Asian fixed-income markets, which are supported by strong economic fundamentals. We do not think the steep correction from May through June of 2013 will be repeated. While the broad, high-growth period for Asian economies may have matured, the region continues to have among the strongest growth prospects globally.
Fundamentals have also improved markedly as many Asian economies have embarked on significant macroeconomic developments over the past decade, which resulted in stronger sovereign balance sheets, more robust banking systems and more sophisticated capital markets. This has resulted in improving sovereign credit profiles. Today, nine of the 10 major Asian sovereigns are rated as investment-grade by S&P, Moody’s and Fitch.
While we may not expect to see historically strong performance of Asian fixed-income and currency markets, we also do not see collective underperformance across all markets. Therefore, an important theme in Asian fixed-income markets in 2014 is divergence of performance across markets. This will provide opportunities to capture selective outperformance across country, currency and credit selection.