Hong Kong investors have been piling into bonds of late, following a global flight from imploded equities into quality. For the many who have recently bought the Schroder Hong Kong Dollar Bond Fund, there should be rewards for those who hold long term, says fund manager Selina Tsang. The money in the fund has jumped from just HK$25 million at the start of last year to HK$725 million at the end of July as retail investors discovered there was a world beyond sinking stocks. 'I think this is somewhat new to retail. The retail interest in bonds and fixed interest, especially domestic fixed interest instruments, only came recently,' said Ms Tsang. Besides fleeing equities, investors were tuning in to the changed economic environment in Hong Kong, she said. The currency peg implemented in 1983 has meant Hong Kong's interest rates have moved in line with those of the United States. The one-size-fits-all monetary policy led to interest rates staying inappropriately low while inflation was high in the late 1980s and early 1990s, resulting in negative real interest rates or interest rates lower than the rate of inflation. With that backdrop, the smart bets were property and equities, which offered a hedge against inflation. Money borrowed one year by consumers and companies could be repaid the next in inflated dollars. That story was bad news for bonds, however, which suffer badly in an inflationary environment with their yields falling behind inflation, resulting in negative real returns. 'One of the aims is to get a return at least higher than inflation to protect your future purchasing power,' Ms Tsang said. Now investors can get that and more as beneficiaries of Hong Kong's deflationary bust. 'Towards the end of the decade there has been quite a change and real interest rates turned to positive territory again. That is the basic fundamental driver for the interest [from investors], especially on the retail side,' she said. While interest rates are low, investors also have to factor in deflation, which adds to the real return for bond investors. The low or negative rates of inflation should be a long-term part of the landscape, particularly given Hong Kong's integration with low-cost China, Ms Tsang said. She is expecting deflation to come in at 1.5 per cent this year. Merrill Lynch is forecasting another 0.4 per cent drop in prices next year. The improvement in the deflation picture is expected to come from a recovery in economic growth. Merrill expects US growth to pick up from 2.5 per cent this year to 3.7 per cent next year while Hong Kong should also improve, picking up from 2 per cent this year to 4 per cent next year. Bond investors can take fright at an upturn in growth as it can signal resurgent inflation and rising interest rates, which destroy returns and can cause capital losses. Ms Tsang is expecting any recovery to be mild with the US Federal Reserve keeping interest rates on hold for much longer than expected this year. She said rates were only likely to be raised later next year, perhaps not even in the first half. Eventually, 'Hong Kong inflation should return to zero per cent or at most 1 to 3 per cent. In the near term, we are not seeing inflation go higher than that,' said Ms Tsang. 'Interest rates will still be in positive territory so investors will still be interested. This is the fundamental secular trend and it is not likely to disappear, although there are cyclical aspects.' The fund has gained 45.48 per cent in the five years to July, 26.43 per cent over three years to that date and 6.56 per cent over one year. Those numbers look good compared to the double-digit losses being nursed by equity investors. 'A lot of the return comes from interest income,' Ms Tsang said. 'Some people might find it boring. It is not like an equity fund where you can get suddenly in one month 10 per cent or 20 per cent.' The staple diet of Ms Tsang's fund is bonds issued by the government's Exchange Fund. Though the government has been debt free, it began issuing bonds in the early 1990s to create a benchmark yield curve against which other issuers' credits could be priced. Her top holding is a five-year Exchange Fund with an annual coupon of 4.76 per cent which makes up 14.73 per cent of the fund. The advantage with government bonds was good liquidity, which meant narrow bid-offer spreads and easy trading, she said. 'Recently, we have been buying government bonds because of the liquidity consideration,' she said. Government debt made up 22 per cent of the HK$400 billion Hong Kong dollar debt market and a typical Exchange Fund issue would be from HK$600 million to HK$1.2 billion, Ms Tsang said. A host of big name financial institutions have also raised debt in the market, providing plenty of choice for Ms Tsang. She also has holdings in debt from the likes of Bank of Scotland, Britain's Abbey National and Landesbank Schleswig-Holstein of Germany. There is abundant liquidity in the Hong Kong dollar market as banks are stuffed with deposits but cannot find solid loan prospects amid the depressed economy, causing them to turn to bonds. The ease of fund-raising has been a magnet for financial institutions. 'A lot of non-government bonds have made private placements, it's quite fashionable in the market for non-government bonds [for subscribers] to hold 100 per cent of the issue,' she said. 'Institutional interest has always been quite big [and] the supply side is not a problem for Hong Kong dollar debt instruments.' The Schroder Hong Kong Dollar Bond Fund has recently been added to the house's Luxembourg-domiciled range. That has resulted in annual management fees being raised from 0.5 per cent to 0.75 per cent but means easier switching with other products. FACT FILE Selina Tsang 1990: Graduated with a master of science degree in management from the Imperial College in London. 1991: Joined Schroder's treasury department as an analyst. 1993: Moved to SG as an analyst and trader in fixed income. 1994: Rejoined Schroders and specialised in fixed interest and money market fund management. 2000: Promoted to associate director of Schroder Investment Management (Hong Kong).