In 2017, Asia bonds had three strong tailwinds— attractive credit spreads, currency appreciation and a favorable interest rate environment. 
In 2018, we expect credit spreads and currency appreciation to continue driving returns in Asia bonds. Local interest rates in Asia could present a slight headwind for bond returns in some countries. In aggregate, however, local interest rates may be a neutral factor across the region.
We expect total returns for Asia bonds to be strong in 2018, but lower than in 2017. The bigger story for Asia bonds in 2018 may be how their performance is poised to compare with US bonds. US interest rates finally started to rise in December 2015 after years of anticipation by market participants.
US Federal Reserve chair Janet Yellen favoured gradual action and we expect her successor, Jerome Powell, to adopt a similar approach. Depending on inflationary pressures in the US economy, the Fed’s target benchmark rate might increase two to four times over the next 12-18 months. Gently tapping the economic brakes at this stage of the economic cycle is a prudent measure to slow a robust US economy.
For current holders of US bonds, rising interest rates would generate losses in bond portfolios as bond prices fall. Rising rates would particularly affect low spread asset classes like US municipals and investment grade corporate bonds. In our view, investors in these asset classes might consider paring back and reallocating capital to securities with lower US interest-rate risk, which include Asia bonds. Below is a look at factors that may affect Asia bonds in 2018.
Attractive Credit Spreads
In our view, Asia high yield bonds look reasonably valued, while US and European high yield bonds appear overvalued. Credit spreads for Asia high-yield bonds are near historic averages. In contrast, spreads for US high yield bonds are about 200 basis points below average while spreads for European high yield bonds are 300 basis points below. In simple terms, Asia high yield bonds are compensating investors for taking credit risk, in our view, while US and European high yield bonds are not.
In 2018, we expect to see a bit more volatility in bond prices and credit spreads. At the same time, we expect many Asia bonds to offer a fairly healthy coupon rate, building a strong base with the potential for positive returns. A bond that starts with a 4 per cent coupon and gains a small boost in currency appreciation, for example, could potentially generate attractive returns for investors who may be experiencing falling bond prices at home.
Positive Currency Appreciation
Asian currencies had a banner year in 2017 and most Asian currencies saw strong gains versus the US dollar. We expect smaller currency gains in 2018, but still positive momentum.
We believe the key tailwinds behind this outperformance will likely continue next year. They include synchronised growth of the world’s three largest economies – the US, Europe, and China; recovery in world exports; and, several Asian currencies being fundamentally undervalued.
For 2018, we expect solid mid-single digit returns for many Asian currencies. Some commentators speculate that US tax reform could result in dollar strength as firms may have more incentives to repatriate the cash offshore back to US. I disagree.
Large US multinationals are already flushed with cash and have been deploying capital to buy back stock. It’s also not clear how much the denomination of that cash changes since cash is an accounting entry.
Whether the cash is in local currency versus USD is dictated more by business needs like working capital than by the US tax code. Overall, we expect positive returns in Asia currencies for 2018 and that the corresponding rising values in Asian currencies will be a tailwind for Asia bonds.
Diverse Drivers for Local Interest Rates
While the global economy is experiencing somewhat synchronised growth, monetary policies can vary widely as different countries grow at different rates. In 2017, interest rates generally did not rise across Asia. Much of Asia maintained a favourable interest-rate environment even as rates were rising in the US.
Central banks in Asia make monetary policy decisions based on local economic conditions, resulting in a diverse set of interest-rate decisions across Asia. Export-driven economies in Asia are starting to see signs of inflation.
Most central banks in Asia have stopped cutting rates and are evolving to a tightening stance as their economies heat up. While interest rates were a tailwind for Asia bonds in 2017, they could be a slight headwind in 2018 if rates rise.
Our view is that any negative impact generated by rising interest rates in Asia would be fairly modest. Even if interest rates were to rise by 25–50 basis points in 2018 across Asia, the cost of capital would still be very low in terms of its historical averages.
Possible Risks
We are most concerned about potential macro issues stemming from the geopolitical unrest in the Middle East and Africa, including Saudi Arabia, Turkey and South Africa.
The one Asian country we are watching closely is Pakistan. We think the Pakistani rupee will need to depreciate more from where it is today. It has historically been dependent on Saudi Arabia as a source of foreign capital. With the current political uncertainty there, Pakistan might experience balance of payment issues should there be delays in the capital from China’s one belt one road program.
In an increasingly interconnected world, geopolitical tensions affect all investors. However, in our view, most of these risks mentioned are idiosyncratic and are unlikely to cause a major contagion that would undermine the global recovery.
The best guidance is to focus on what you can control. Investors can control the quality of portfolios, the duration within portfolios and asset allocation decisions within the fixed income category, including an allocation to Asia bonds.
Building More Resilient Portfolios
As central banks raise rates, many investors are taking a fresh look at fixed income holdings with an eye toward reducing interest-rate risk. Asia bonds can help to diversify portfolios that currently have heavy exposure to US or European government, investment grade or high yield debt.
For global investors, there are often three logical places within a portfolio for implementing an allocation to Asia bonds—emerging market debt, high yield bonds and tactical fixed income products. We believe Asia bonds provide investors with an important tool for building more resilient fixed income portfolios, while meeting a variety of long-term objectives.
Teresa Kong is portfolio manager at Matthews Asia. All views are her own and should not be taken as investment advice.