Asia’s Bond Market Boom Looks Set to Continue

Asia’s debt markets are growing in size and sophistication, giving investors another way to gain Asian exposure. The rapid expansion of the region’s international and local currency bond markets shows little sign of slowing down.

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In the days following Japan’s devastating earthquake and tsunami last month, many bankers worried that the catastrophe would disrupt global capital markets and halt a burgeoning rally in emerging Asia debt. After all, such interruptions have occurred frequently in the past. Last April, for instance, when rating agencies downgraded Greece to junk status, Asia’s offshore bond market shut down for nearly two months. This time, however, the market came back rapidly, notwithstanding the incalculable toll of death and damage in Japan. Just ten days after the earthquake, the Republic of the Philippines made an international offering of $1.5 billion of 15-year bonds. The securities attracted orders from 280 investors from Asia, Europe and the U.S.

“There is volatility, but the markets are open, and opportunity is there,” says Patrick Tsang, Hong Kong–based head of fixed income for Asia at Deutsche Bank, one of the issue’s book runners. “More bonds are in the pipeline.”

The rapid expansion of Asia’s international and local currency bond markets shows little sign of slowing down, even if several countries in the region are beginning to boost interest rates in a bid to contain inflation. Global appetite for Asian debt remains voracious, and the list of governments and companies lining up to sell bonds at home and overseas continues to grow. Cross-border bond sales in Asia, excluding Japan, Australia and New Zealand, amounted to $27.9 billion between January and March 28, up 25.5 percent from the same period a year earlier, according to data provider Dealogic. That pace puts the region on track to surpass last year’s record volume of $101.7 billion.

Corporations are leading the bond bonanza, accounting for almost half of all Asian international issuance this year, compared with just 22 percent a year earlier. Most companies borrow in the so-called G-3 currencies — the dollar, euro and yen. Recent issuers have included such blue-chip firms as Singapore Telecommunications, Southeast Asia’s biggest telephone company, which sold $600 million of 10.5-year bonds in March, and South Korea’s Woori Bank, which raised ¥50 billion ($610 million) with a three-tranche offering of one-year, 18-month and two-year bonds in Japan.

The market for cross-border issues in local currencies, which barely existed five years ago, has also taken off, with issuers raising $4.8 billion in the first two months of the year, approaching the $5.53 billion total for all of 2010. A surge in so-called dim sum bonds, or Chinese renminbi-denominated bonds sold in Hong Kong, is fueling the growth. Roughly 50 borrowers have tapped the market since Chinese and Hong Kong authorities relaxed rules in July to allow companies and investors to hold more renminbi in Hong Kong, more than doubling the total amount outstanding to the equivalent of about $13 billion.

Investor demand for the steadily strengthening Chinese currency has led such fund managers as HSBC Global Asset Management and Hong Kong’s Income Partners Asset Management to start offshore renminbi bond funds. The rush has even led to the creation of synthetic offerings — bonds denominated in renminbi, or yuan as the currency’s unit is called, but settled in U.S. dollars. In March, China’s Evergrande Real Estate Group sold 9.25 billion yuan ($1.4 billion) of synthetic renminbi bonds in two tranches. In addition to setting a record for a synthetic deal, the issue represented the biggest Asian high-yield bond ever. The bonds carry a B2 rating from Moody’s Investors Service and BB– from Standard & Poor’s.

“Asia fixed income has become an exciting and interesting asset class,” said Hon Cheung, the Singapore-based regional director for official institutions at State Street Global Advisors. “That’s unusual to say about bond markets, since equity markets are supposed to be sexy and exciting.” State Street is putting its money where its mouth is. The firm now manages about $2.5 billion in Asian local currency bonds, up from $1 billion five years ago.

The fervor surrounding Asia’s bond markets is a decided turnaround from the late 1990s, when the Asian financial crisis snuffed out a first attempt to get a regional bond market off the ground. The crisis caused credit to dry up across the region, forced several governments to devalue their currencies and turn to the International Monetary Fund for bailouts and prompted dozens of borrowers — led by Indonesian and South Korean companies — to default on more than $40 billion worth of bonds.

Over the past decade, however, Asian economies have come roaring back, led by China’s rise as a global export powerhouse. Governments across the region have built up unprecedented foreign currency reserves. The Asian Development Bank worked with national Treasuries and central banks to develop a bond market in a bid to keep the region’s surpluses at home to foster regional growth.

The results have been dramatic. Emerging East Asia’s international and domestic bond issues amounted to $463.7 billion last year, three times the volume of $154.6 billion issued in 2006, Dealogic statistics show. The region’s share of global bond issuance has more than tripled since the Asian financial crisis, reaching 7.4 percent last year, compared with 2.1 percent in 1997, according to the ADB.

The value of bonds outstanding in the region’s domestic bond markets reached $5.2 trillion at the end of 2010, representing an 18.3 percent gain from a year earlier and a threefold increase from five years earlier, according to the ADB. And there’s still plenty of room to grow. The size of the emerging East Asia bond market is now about 60 percent of the region’s gross domestic product, less than half of the size of comparable bond markets in the United States and Japan.

The market still has some ways to go to develop the liquidity and robustness of debt markets in Japan, Europe and the U.S. A greater variety of issuers would help, given that East Asia’s domestic bond markets continue to be dominated by banks and other financial institutions. In the case of China, where the government is moving slowly and deliberately to liberalize the use of its currency, debt markets still act mainly as a conduit between the government and state-owned institutions. “Regional governments have been cautious, and some have been downright cowardly and are being dragged along,” says Marshall Mays, director of Emerging Alpha Advisors, a Hong Kong–based fund manager and adviser.

No one doubts that the Asian bond market is here to stay, though. If manufacturing and trade served as the backbone for emerging Asia’s three decades of sustained economic development, credit arguably will provide the fuel for regional growth in the years ahead. “This is just the beginning of an explosive boom in Asian credit,” says Soofian Zuberi, head of Bank of America Merrill Lynch’s global markets distribution for Asia-Pacific.

A strong regional economy is driving the growth of the bond market. Bolstered in the wake of the global financial crisis by more than $720 billion in fiscal stimulus and low interest rates, developing Asian economies grew by 9.3 percent in 2010, according to the IMF. The pace of expansion is expected to ease to 8.4 percent this year, but that is still some 2 percentage points above the average for all developing economies globally. The IMF predicts that China will continue to drive the global economy with growth of 9.6 percent this year, compared with 10.3 percent in 2010.

Bond deals are getting bigger, driven largely by Chinese government agencies and state conglomerates selling debt on the country’s domestic market. State Grid Corp. of China, the mainland’s leading utility, sold 30 billion yuan in ten- and 15-year bonds in the biggest local-currency corporate deal last year. Other Chinese state-owned corporations — including Bank of China, China National Petroleum Corp. and PetroChina Co. — also issued local bonds approaching $3 billion or more. Chinese agencies, government ministries, banks and companies accounted for all 20 of the biggest Asia local-currency bond deals in 2010. In the cross-border market, the top 20 Asia ex-Japan bond issues in 2010 each totaled $1 billion or more.

Asia’s strengthening economies have led to improved credit profiles for many governments and companies, which in turn is helping to drive the growth of bond borrowing. In November, Moody’s raised its sovereign debt rating on China by one notch, to Aa3. Standard & Poor’s matched that move in December by lifting its China rating to AA–, and also raised its ratings on several Chinese companies, including China Life Insurance Co. and China National Offshore Oil Corp. Indonesia, the Philippines and Thailand also received ratings upgrades over the past year, making it easier for them to tap the markets. The governments of Indonesia, Malaysia, Sri Lanka and Vietnam each sold $1 billion or more of international bonds last year.

Creditworthiness among the region’s corporations also has rebounded, allowing more banks and companies to raise funds and expand operations. Moody’s took 32 positive ratings actions on Asian companies last year and 32 negative ones, compared with 87 negative actions and 20 positive ones in 2009. The improving credit trend is allowing businesses throughout the region to gain greater access to cross-border bond markets. In October, India’s Reliance Industries, an energy conglomerate, made its first appearance in the international market by selling a total of $1.5 billion in ten- and 30-year bonds. Eight days later, South Korea’s Pohang Iron and Steel Co., the world’s third-biggest steel manufacturer, sold $700 million of ten-year notes, the first global deal of that maturity by a South Korean company since 2007.

Corporate bonds now comprise roughly 30 percent of the region’s domestic bond markets — or about 45 percent of emerging East Asia markets if China is excluded. Still, corporate leverage remains low. Net debt stands at 1.1 times companies’ earnings before interest, tax, depreciation and amortization, on average, down sharply from 5.5 times ebitda at the end of the 1990s, according to analysts at BofA Merrill Lynch.

In 2010 more than 50 Asian companies and banks sold their first overseas debt, primarily in the G-3 currencies. Many turned to high-yield issues, or junk bonds, a trend that Paul Au, Asia head of debt syndication for UBS, finds encouraging. “Now you’re seeing not only your typical triple-A issuers like Temasek Holdings hitting the market but speculative-grade China property names, coal miners from Indonesia, gaming companies from Macau and the Philippines,” he says. Cross-border G-3 junk issues amounted to $18.7 billion last year, more than double the volume of 2009, according to Dealogic.

Asian companies are also selling debt as a means to improve their capital structure, lower existing interest payments and extend debt maturities. Last year, Bank of China (Hong Kong), which is two-thirds owned by China’s third-biggest lender, sold $2.5 billion in subordinated debt to replace an existing subordinated loan from its mainland parent.

Other companies are issuing bonds to finance strategic activities, including offshore mergers and buyouts. Last month, Hyva Global, a Dutch maker of truck hydraulic systems, raised $375 million with a high-yield bond offering to help fund the company’s €525 million ($730 million) leveraged buyout by Hong Kong–based private equity firms Unitas Capital and NWS Holdings. The deal was the first LBO in Asia in more than three years.

The wave of international bond financings has given a welcome boost to global banks such as HSBC Holdings, JPMorgan Chase & Co. and Deutsche Bank, and many banks continue to add staff to service the expanding market. When Tsang joined Deutsche eight years ago, the Frankfurt-based bank’s debt capital markets team in Asia basically served only sovereign and quasi-sovereign borrowers. That has changed. “We now also cover frequent corporate issuers, high-yield as well as leverage and acquisition financing,” Tsang says.

Regional bond offerings are attracting increasing interest from international fund managers and affluent local investors. The proposition remains simple: Asian bonds, and in particular junk debt, pay outsize coupons and give investors exposure to currencies that are expected to continue to appreciate. Investment flows into emerging Asia debt rose to $62.4 billion in 2010 from $45.2 billion a year earlier, according to the Institute of International Finance, a Washington, D.C.–based association of financial institutions.

The development of local credit markets has attracted a wide range of global investors. BlackRock, State Street Global Advisors and bond fund manager Pacific Investment Management Co. have been active in Asia for years, but increasingly they are now rubbing shoulders with European and U.S. private banks that are expanding in the region. “Asian markets are providing a source of diversity rather than a source of risk for investors,” said Gregor Carle, investment director for fixed income at Fidelity International in Hong Kong. Assets managed at Carle’s Asian High Yield fund have increased tenfold over the last two years, to $2.2 billion.

Demand isn’t just coming from international buyers. Primary buyers of many bond issues, including high-yield issues, now reside in Asia. “There’s been a huge increase of wealth and affluence, and that creates a greater pool of savings,” said State Street’s Cheung. Asia-Pacific’s population of high-net-worth individuals increased to 3 million in 2009, while their wealth grew 30 percent to $9.7 trillion, according to World Wealth Report compiled by Capgemini and Merrill Lynch Wealth Management. “In 2007, to launch a high-yield deal you had to fill the order book in the U.S. and Europe to get any traction in Asia,” said Graham Conran, head of origination for Asia ex-Japan at Nomura International (Hong Kong). “Now, it’s just the opposite. The core market is here. Depending on the investment grade and the terms, the likelihood of getting across the finish line without a robust Asia book is very much diminished.”

One indication of global appetite for Asia debt can be found in HSBC’s latest quarterly survey of fund managers. The poll, released last month, showed the world’s biggest fund managers remained relatively optimistic about Asian bonds in the first quarter even as they shifted assets away from Asia ex-Japan stocks in favor of North American equities.

The flood of cash rushing into local markets hasn’t been lost on some regional governments, which have posted barriers and regulations aimed at stemming cross-border capital flows and dampening currency appreciation, even as they raise interest rates. In recent months the Indonesian central bank stopped auctioning three-month paper, and started auctioning nine- and 12-month paper, while imposing a minimum 28-day holding period. In October, Thailand reinstated a 15 percent withholding tax on capital gains and interest income on foreign holdings of domestic government, state enterprise and central bank bonds. The following month South Korea announced it was reinstating a withholding tax on foreign investment in local bonds, sparking a sell-off of foreign-held treasury bonds at the end of last year.

Asia’s rapidly growing bond markets, surprisingly enough, are grounded in the wreckage of the Asian financial crisis, which began in 1997 and brought to light, among other things, the serious balance sheet problems of the region’s banks and their clients. Financial institutions from Bangkok to Seoul had taken out massive loans in U.S. dollars and Japanese yen and then lent those funds to businesses that earned their revenues in domestic currency. The mismatch helped to inflate local asset prices and led to outsize borrowing by local companies.

The crisis crippled local currencies and ravaged regional economies. “That was a watershed,” said Sabyasachi Mitra, senior economist at the Office of Regional Economic Integration of the ADB. “A strong local currency bond market could have mitigated these problems.”

By 2002, Thailand’s then–prime minister, Thaksin Shinawatra, was leading the call for development of local-currency debt markets. “Isn’t it time for Asia to explore setting up an Asian bond market as a financial instrument to help in maximizing our continent’s potential and prevent exploitation of our reserves by others against the interests of ourselves,” Thaksin told regional leaders at the World Economic Forum in Kuala Lumpur that year.

Prodded by the ADB, regional governments launched a series of programs aimed at detecting financial and macroeconomic risk, while encouraging the development of local-currency debt markets. The Asian Bond Market Initiative was inaugurated in 2003 with the participation of finance ministers from member countries of the Association of Southeast Asian Nations — Brunei Darussalam, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand and Vietnam — as well as China, Japan and South Korea. In 2009, ABMI issued a new road map aimed at improving domestic issuance, facilitating demand and standardizing bond issuance, trading infrastructure and regulation across the region.

In 2003 a separate grouping of 11 Asian central banks and monetary authorities launched the Asia Bond Fund, which invested $1 billion in a basket of liquid U.S.-dollar bonds of major Asian economies, excluding Japan, Australia and New Zealand, and managed by the Bank for International Settlements. A second fund was started the following year, with eight separate country-specific subfunds.

The ADB remains a strong proponent of regional financial integration and continues to facilitate standardization efforts alongside ABMI. The multilateral development institution also has acted as a pioneer bond issuer, selling landmark international debt, along with several benchmark domestic bonds. In 2005, ADB issued the first so-called Panda bond, a Chinese local-currency bond that raised 1 billion yuan in a ten-year note. In October 2010 the Manila-based organization sold the first international bond denominated in Chinese currency in Hong Kong. The 1.2 billion yuan sale carried a ten-year bullet maturity.

Those efforts are bearing results, says ADB’s Mitra, especially in the aftermath of the global financial crisis. Domestic bond sales regionwide now comprise about 80 percent of total issues, according to Dealogic. Many markets also have widened their investor base to increase participation by nonbank financial institutions and offshore investors, including Indonesia, where foreigners last month held about 30 percent of tradable government securities. Ongoing access to local-currency debt markets allowed many Asian companies to raise capital that helped them avoid the worst effects of the liquidity squeeze affecting many parts of the international capital markets.

Regulators should do more to foster the market’s growth, such as improving the depth of secondary market trading, says Mitra. “There’s a need for greater diversity of investors and traders,” he explains. “Lack of market liquidity not only hinders pricing of financial assets, it also inhibits financing by central banks and governments.”

Investors also want to see banks make a greater commitment to market making, explains Jeremy Amias, director of Amias Berman & Co., a global fixed-income advisory and brokerage firm. For Asia’s international bond market, that has started to change with the establishment of dedicated global Asia bond funds. “For many years Asia’s offshore bond markets were dogged by the fact that there was no buyer of last resort,” he says.

Local markets, nonetheless, continue to provide only a small fraction of total domestic financing throughout the region, while corporate bond sales remain closely tied to government agencies, state-owned firms and financial institutions. Even in South Korea, which boasts a $1 trillion domestic bond market, almost one third of local corporate bonds are issued by special government-affiliated institutions such as Korea Land & Housing Corp., Korea Housing Finance Corp. and Korea Electric Power Corp.

China, the region’s biggest debt market with more than $3 trillion of bonds outstanding, faces particular challenges. Over the past five years, Beijing has implemented a series of reforms to jump-start the country’s corporate bond market, and companies now account for about 20 percent of total issuance. Yet the government still controls most debt issuance, either directly with the sale of government bonds and central bank bills or indirectly through offerings by government-affiliated agencies and conglomerates and state-owned banks, says Michael Pettis, a finance professor at Peking University. The absence of a convertible currency ensures the government can maintain control of interest rates. “That means China’s financial markets, including its bond markets, are not able to perform one of their major functions: estimating the cost of capital,” Pettis says. “What corporate bond market is permitted, there’s only partial disintermediation since it’s still funded through the banking system.”

Under such circumstances, foreign direct investment in local currency securities remains limited to the $20 billion allotted under China’s Qualified Foreign Institutional Investor program.

Establishing healthy capital markets requires “a constellation of factors that can be difficult to assemble,” observes Tom Schiller, head of Asia-Pacific for Standard & Poor’s. “They include a solid trading platform and dependable market-making community, a legal regime that protects creditor rights and a broad base of institutional investors and borrowers.”

Most of those elements are coming together rapidly in Asia, however. The market has reached such a size that companies need to issue between $42 billion and $50 billion a year for each of the next five years just to refinance maturing bonds, according to Moody’s estimates. Ample regional liquidity and efforts by global institutions to increase their exposure to Asian debt should ensure plenty of demand for those offerings, says State Street’s Cheung.

This Asian credit boom, unlike its 1990s predecessor, looks set to last.

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