Questions & answers

A flight to quality instruments has triggered a rally in global yields, but inflationary pressure remains

State Street Global Advisors is the manager of the ABF Pan Asia Bond Index Fund, an exchange traded fund listed on the Stock Exchange of Hong Kong. The fund invests in eight regional currency bond markets in Asia as it seeks to track the returns of the iBoxx ABF Pan Asia index.

Even though bonds could be a safer choice in a market which had become significantly volatile in the past few months, fixed income investors had to be aware of high inflation, said Ramon Maronilla, vice-president and senior portfolio manager at State Street Global Advisors global fixed income group.

What is happening with the global bond market now since the breakout of the subprime mortgage crisis? The subprime mortgage crisis in the United States has caused widespread risk aversion and delivering of trades, causing a flight to quality instruments such as government bonds and the relative underperformance of spread product such as credit, asset backed securities, and even US agency mortgage backed securities. This has triggered a rally in global yields, credit spread widening and increased correlations across global developed bond markets at a time when diversification is needed the most. As world trade surges and economies become more integrated, so do the performance of their financial markets. Even in the emerging markets, and particularly in Asia, the 'decoupling' story has somewhat given way to a 'recoupling' reality, as reflected in the heightened volatility of the region's markets in response to negative developments in the US. Asian bonds have to lesser and varying degrees tracked the movements in developed market interest rates, while Asian credit spreads have also widened significantly to reflect heightened risk premiums across the region.

What are the recent most significant strides in the development of Asian bond markets? Asian bond markets have experienced significant strides in their growth and development, moving gradually towards the levels more characteristic of the developed bond markets. The size of the region's markets have tripled to about US$3.6 trillion since 1997, and now encompasses 6 per cent of the global bond universe. Deregulation, structural developments, and prudent monetary and fiscal policies have all contributed towards the stability and strength of the region's financial systems, leading to a string of upgrades in sovereign ratings. Growing global demand for Asian bonds has also helped increase liquidity and drive down bid-ask spreads, sustaining a virtuous cycle of increasing investor participation, enhancements in liquidity, expansion of infrastructure and increases in issuance, further encouraging participation. The derivative and repurchase markets are rudimentary, and more needs to be done to build the operational and regulatory infrastructure necessary to support further growth in this area. While futures markets exist in Malaysia, South Korea, Taiwan, Hong Kong and Singapore, they are not very liquid. The other sectors to watch for are the development of structured products, Islamic financing and inflation-linked bonds. While these sectors are still small relative to the sovereign markets, there have been recent exciting developments that are paving the way for continued growth.

What is the impact of the United States Federal Reserve interest rate cuts on Asian bond markets and inflation in the region? The Fed's interest rate cuts are causing a weakening of the US dollar due to the perceived worsening of US economic conditions and rising interest rate differentials. For the Asian countries whose currencies are pegged or closely managed against the US dollar, this also means falling short-term bond yields and depreciating currencies, particularly against the euro and the yen, giving rise to inflationary pressures.

For those with more flexible currency regimes, general US dollar weakness has led to appreciating currencies, and that may help cushion against rising import prices of energy and commodities. In either case, robust Asian demand has allowed producers to pass on higher manufacturing costs to consumers, translating into upward pressure on prices. However, these inflationary drivers will be mitigated by the anticipated severe slowdown or even recession in the US, which would very much affect Asia's economies, particularly those which are more open and vulnerable to the global economic cycle. The deeper and longer the slowdown in the US, the more price pressures will ease in the region. The Fed rate cuts in the United States also mean that global investor risk appetite is reduced, which may create a dichotomy of Asian bond market performance, causing higher credit quality countries to outperform the lower rated ones.

What's the performance of the ABF Pan Asia Bond Index fund so far? What were the major drivers of performance? The ABF Pan Asia Bond Index fund has delivered an annualised net return of 10.4 per cent from inception in 2005 to February last year. Performance has been driven by coupon income, currency appreciation and, to a lesser extent, capital appreciation. The falling appeal of the US dollar and US dollar assets coupled with higher expected returns from emerging markets have boosted returns from Asian bonds. Despite the recent turmoil in the financial markets, the fund's returns have also exhibited relative stability, thanks mainly to the nature of bonds and the diversification that investing in eight local interest rate and currency markets provides.

How did SSGA decide on which index to use? The fund is managed against a customised index that seeks to broadly represent eight of the region's local bond markets, with careful consideration of the size, liquidity, credit rating and functionality of these markets and the securities to be included in the index. The index provides wide exposure to the region's bond and currency markets, and highlights the diversification aspects of investing in such a broad range of economies.

What other products will SSGA launch under present market conditions? SSGA is looking to launch an Active Asian Bond Fund in the second half of this year, driven by the structural trends that we're seeing in the marketplace and the resulting increase in demand for such a strategy. The search for diversified sources of extra returns, coupled with investors' expansion of their universe of investible securities, makes for the ideal backdrop to develop capabilities in the space.