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Asian bond rally may be overcooked

Asian US dollar-denominated bonds have been a boon for investors in the past few years, led by improving credit fundamentals and mild disinflation.

Of late, however, there are indications the rally is overcooked. Interest rates are at their lowest levels for four decades following the United States Federal Reserve's quarter-point rate cut last week, which has weakened investor confidence in US treasuries in the process.

Cheaply priced bonds have become increasingly rare and credit spreads - the amount by which corporate bond yields exceed the yield on treasuries - have narrowed as profit margins and balance sheets improve, while the rate of corporate defaults declines.

Many market watchers expect the United States to hit 4 per cent growth next year with the attendant likelihood of higher inflation.

With the prospects for Asian equities appearing to offer good value, many investors are reassessing their bond strategies.

'Successful bond investing has become much more of a challenge. Two years ago, you could have bought just about any Asian US dollar bond and the chances are that since then, you would have seen credit spreads tighten dramatically,' said Damien Wood of ING Financial Markets.

In the short term, stocks look better bets than bonds but according to Citicorp Smith Barney regional head of strategy Ajay Kapur, it is debatable whether this holds true for the longer term.

'In a deflationary environment, bonds normally do reasonably well, unless that deflation is countered by massive policy responses which are unlikely to happen in Asia,' he said.

Mr Kapur said that as a general rule of thumb, bonds outperform equities in emerging markets as debt issues require improving macroeconomic conditions. The fundamentals for most of Asia were unlikely to change, he said.

HSBC fixed-income analyst Dilip Shahani said investor perspectives on bonds should be based on their outlook for the global economy. He said improved investor sentiment towards equities was driven by belief in a second-half recovery.

'The amount of fiscal stimulus that central banks have put into the system makes now the time to be in equities. But from a longer-term perspective, the fundamentals have not significantly changed,' Mr Shahani said, pointing out that the Asian market was driven by the US market, which had not changed in any sustainable way.

'If [Asian] economies are going to be growing at sub-par activity, then bonds are not vulnerable,' he said.

Mr Wood said the best bond buys in the present climate were non-investment grade Asian sovereign and corporate bonds that offered decent returns and were less sensitive to fluctuations in US treasuries yields.

High-grade Asian sovereign dollar bonds were essentially US treasury proxies because they were so vulnerable to US treasuries, he said.

ING recommends corporate bonds from the Philippines such as Equitable PCI-Bank and Philippines Long Distance Telephone.

For Hong Kong bonds, the investment bank favours Li Ka-shing family companies such as debt issues by Hutchison Whampoa maturing in 2011 and 2013.

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