However, he believes the three risks have subsided. “It is a rare time for Asia that all these three good things are happening all at once, which puts Asia bonds in a nice sweet spot,” he told FSA on a recent visit to Hong Kong.
The US Federal Reserve’s expected interest rate cut should be favourable for the region, he said. “[Conversely] emerging market bonds become weak whenever the Fed is tightening.”
Inflation is also low in the region, driven by lower commodity prices, which Fu expects to remain stable for the next few years. He explained that China has been driving commodity prices the past 20 years, but is expected to consume less due to reduced infrastructure spending.
"When Argentina blew up this year, we were worried that this might affect Indonesia"
“Other Asian economies can now build at lower costs, and you see a pick up in infrastructure activity in the Philippines, Indonesia and India.”
Apart from Hong Kong, political stability characterises the region, especially in Southeast Asian countries, which have concluded all three elections with strong approval ratings, Fu said.
He would not comment on the ongoing political turmoil in Hong Kong, but noted that the firm’s Asia fixed income portfolios do not have significant exposure to Hong Kong bonds.
“We always have had close to zero in Hong Kong dollar-denominated bonds due to the lower yield than in US treasuries.”
Asia’s current sweet spot, he said, may last two-to-three years, given that stability is dependent on the region’s political cycle.
“In Asia, you can only look forward as far as the political cycle. The reality is that fundamentals are very bright and that the population is growing. But if the political situation destabilises, you may have to quickly change each investment strategy in each country.”
One of the challenges of managing an Asia-focused bond fund is that managers have to be aware of what is going on globally and not just focus on Fed policies.
“When you have a large crisis in a single non-Asian emerging market country, sometimes there are spillover effects. For example, when Argentina blew up this year, we were worried that this might affect Indonesia.”
He said emerging market managers are unlikely to immediately sell Argentina holdings because they have lost a lot of money. Instead, they would sell perceived high risk assets that have not yet been impacted.
Fu explained that the firm’s Singapore-based team had to ask for feedback from its Pasadena- and London-based teams on whether the Asia sentiment would change because of Argentina.
“The reality was, Indonesia continues to be very attractive with good yields, which is why it was not that affected.”
Indonesia and India
For Fu, Indonesia and India are the preferred regional bond markets, with yields around 7%. They have also led in regional returns:
Both markets are among the largest positions in the firm’s Asian Opportunities Fund, which focuses on local currency investment grade government and corporate bonds.
Western Asset Opportunities Fund
Fu, however, is cautious on Malaysia because foreign exposure to its domestic government bond market is high – at around 38.7%, which can easily affect fundamentals in the event of a sell-off.
He prefers markets in which local institutions, such as pension funds and insurance companies, are huge investors in the local bond market because they tend to be long-term. They keep the bond market more stable. Examples are China, India and Thailand.
The fund also has the option to hedge in other currencies.
“If we are seeing a beta risk in a currency, such as the strengthening or weakening of the US dollar, we can take a hedge using a range of other currencies, such as the Australian dollar, the euro or the Japanese yen.
“But if the currency is affected by problems of the country on its own, then having a beta hedge is useless. We would have to evaluate whether we have to trim the position.”
The Legg Mason Western Asset Asian Opportunities Fund versus its sectors in Hong Kong and Singapore