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.