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Creating a More Efficient Fixed Income Portfolio With Asia Bonds

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Asia fixed income offers investors attractive total return potential and distinct investment characteristics that can help improve the overall risk/return profiles of their fixed income holdings. For U.S. investors whose fixed income portfolios are predominantly exposed to the U.S. fixed income markets, Asia fixed income provides currency diversification, the potential for yield enhancement and exposure to markets that follow different economic and credit cycles.

Challenges for Fixed Income Investors

In a low-yield environment, many investors may already be looking outside traditional fixed income benchmarks for yields. For example, some investors may be adding high yield, global or emerging market bonds to their portfolios, rather than relying exclusively on traditional exposures such as the Barclays Global Aggregate Index (Global Aggregate) or the Barclays U.S. Aggregate Bond Index (U.S. Aggregate). The result is a global search for yield. However, in a difficult environment for fixed income investing, some investors may be tempted to reach for yield without thoroughly considering how much risk is being added in exchange for the incremental yield gained.

Investors also recognize the need to include a more diverse range of bonds in client portfolios in order to create ‘all-weather’ investment strategies. Recent increases in duration and in the correlations among common fixed income investments lurk in the background. The U.S. Aggregate, which contains a mix of bond sectors, can provide a starting point for viewing some of the trends taking place in the broader fixed income marketplace. Consider changes in the index over the past decade. Duration in the index has increased by 1.3 years, while the proportion of Treasuries in the index grew by 11.1 percentage points.

As duration in the U.S. Aggregate has increased, investors using the index as a core bond holding may be subject to higher levels of interest rate risk than in the past. In addition, diversity of the index has decreased as the proportion of Treasuries has increased.

A More Efficient Fixed Income Portfolio

Asia fixed income has the potential to help investors achieve higher yield and better total return for their fixed income portfolios within a defined risk/return framework. In other words, adding Asia fixed income to an investor’s overall fixed income portfolio may create a more efficient portfolio on a risk-adjusted basis over the long term.

With a long-term perspective in mind, investors may reap the rewards of investing over a full market cycle.  If we compare the risk/return characteristics of the local currency denominated Asia Bond (HSBC Asian Local Bond Index) and the U.S. dollar denominated Asia Bond (J.P. Morgan Asia Credit Index) against a range of core developed and emerging market indices we would illustrate where Asia fixed income is positioned along the risk/return continuum, and provide investors with a distinct asset class in either local or U.S. dollar currency and delivering an attractive return per unit of risk.

Asian fixed income historically has also exhibited relatively low sensitivity to U.S. interest rates compared to other mainstream fixed income segments.

We note that, over the short term, Asia fixed income has the potential to be more volatile than U.S. bonds or Global bonds and therefore investors to have a time horizon of at least three to five years in mind when considering Asia fixed income.

Multi-Currency Bond Portfolios Offer Fixed Income Diversification Benefits

Asia fixed income represents two distinct bond markets—local currency and U.S. dollar bonds. The local currency bond market, represented by the HSBC Asian Local Bond Index, is about $1.73 trillion (larger than the U.S. high yield bond market) and offers currency diversification. The U.S. dollar bond market in Asia, represented by the J.P. Morgan Asia Credit Index, is about $570.5 billion. These two markets together provide compelling investment opportunities across the three return drivers of credit, currencies and interest rates.

Although predictions regarding currencies can be difficult over a short-term horizon, we believe that over the long run there is a strong structural argument for the appreciation of many Asian currencies relative to major global currencies. In many Asian countries today, we see healthy government and corporate balance sheets, falling inflation, higher foreign exchange reserves and lower external debt. We believe that strong regional fundamentals—absolute and relative—combined with deepening capital markets and different interest rate cycles make a compelling case for including local Asia currency exposure in investors’ portfolios.

Asia fixed income has historically exhibited low correlations to U.S. and other fixed income markets. One reason is that a multi-currency portfolio of Asia fixed income investments has different and more diverse drivers of return than a single currency portfolio. For example, U.S. government bond returns are driven primarily by changes in interest rates.

In contrast, returns for a multi-currency fixed income portfolio such as a diversified Asia fixed income portfolio will be driven by three distinct elements—credit, currencies and interest rates. The diversity of these risk and return drivers results in low correlations with mainstream fixed income segments.

Comparison With Other High Yielding Sectors

To compare Asia fixed income with emerging market or high yield bonds, it is prudent to look beyond yield. Currency fluctuations tend to render misleading straight yield comparisons between single currency and multi- currency bond strategies. More effective metrics to consider may include total return and volatility. By taking a more holistic view of higher-yielding bond sectors, investors can make more informed choices when constructing their portfolios.

A Distinct Asset Class

While Asia fixed income is often included as a sector within global bond indices and emerging market bond indices, the exposure gained through these indices is relatively small. For example, Asia ex Japan fixed income makes up only 3% of the Barclays Global Aggregate Bond Index and 21% of the J.P. Morgan Emerging Markets Bond Index Global.

Asia fixed income is systematically underrepresented in global indices because Asian countries have less debt than those in other regions. For example, Figure 8 illustrates how the top country allocations within global emerging market bond indices also have higher levels of debt to GDP. Conversely, countries in Asia with less debt typically have a lower representation in global emerging market benchmarks.

With Asia fixed income being systematically underweighted in both global and emerging market benchmarks, we believe that investors can benefit from treating Asia fixed income as a distinct allocation within their broader fixed income portfolios.

The Importance of Active Management

Employing a passive approach typically results in a suboptimal portfolio because the overwhelming majority of benchmarks are weighted by market capitalization. When applied to fixed income, this results in benchmarks with the highest allocations to issuers with the most debt, not the highest credit quality. Consequently, a passive portfolio would expose the investor to the most indebted issuers, not the most creditworthy issuers. Given Asia’s strong fundamentals, this often leaves global fixed income investors far less allocated to Asian issuers than they might expect or intend.

Additionally, portions of the Asia fixed income markets remain relatively inefficient, which creates opportunities for active managers to generate alpha through fundamental analysis of credit, currencies, and interest rates across the region.

Getting Started

Many investors are already looking beyond broad market benchmarks when building fixed income portfolios. For investors who may be looking to diversify portfolios away from their home country bond sectors, Asia fixed income can serve as a strong diversifier. Rather than thinking about Asia fixed income as part of the emerging markets debt category, we encourage investors to think about Asia fixed income as its own distinct asset class. Because Asia fixed income is a relatively inefficient asset class compared to U.S., European and Global bond markets, choosing an active manager can potentially help to mitigate risks and enhance returns. Clearly, allocations to Asia fixed income should be tailored to an individual client’s objectives, time horizon and risk tolerance. Over the short term, Asia fixed income has the potential to be more volatile than some U.S., European bonds or Global bond markets and, therefore, investors should have a time horizon of at least three to five years in mind when considering Asia fixed income. However, for investors who are focused on the long term, including an allocation to Asia fixed income may help to improve the risk return profile of their fixed income portfolio.

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