Asian short duration bonds: one of the ways to put your cash to work

After a tumultuous 2022 punctuated by surging inflation and interest rates, we believe that fixed-income assets are nearing an inflection point.

Indeed, the U.S. Federal Reserve (Fed) has raised the federal funds rate to 5.00% to 5.25%, while 10-year U.S. Treasuries have shown great volatility, rising roughly 225 basis points (bps) since the start of last year. As a result, fixed income posted negative returns in 2022, prompting many investors to place their excess cash in bank deposits to escape market volatility.

The evolving macro landscape offers an attractive entry point for fixed-income investors

However, the global macro landscape is changing. Inflation in the United States has gradually decelerated but remains high in 2023: from 6.4%  in January to 4.9% in April in year-over-year terms. Fed Chair Jerome Powell also recently stated that continued volatility in the nation’s banking sector might tighten credit conditions further through lower lending levels, potentially enabling the U.S. central bank to halt rate increases at a lower level than it might have needed to otherwise.

While the Fed’s monetary tightening cycle might not be over, we believe that we’re closer to the end of the cycle than the beginning. Furthermore, the potential upcoming pivot in Fed policy offers opportunities for fixed-income investors.

Interest rates should remain higher over the short term due to sticky inflation that remains above the Fed’s target of 2%. Yet significant additional rate hikes seem unlikely amid lower inflation, particularly since first-quarter GDP and recent monthly retail sales data suggests the U.S. economy is decelerating.

Therefore, fixed-income investors have an attractive entry point: They receive current elevated yields while also potentially benefiting long term from capital appreciation if interest rates gradually move lower. In contrast, bank depositors may face reinvestment risk to achieve the same level of returns once their deposits mature after the Fed’s pivot.

With this changing macro backdrop in mind, we think investors would be well served to understand how Asian short duration investment-grade (IG) U.S. dollar bonds (USD bonds) can maximize opportunity in the current environment.

The advantages of Asian short duration IG USD bonds

There are benefits to investing in Asian USD bonds. In this section, we focus on Asian short duration (0 to 3 years) IG corporate bonds.

Credit risk can be mitigated by Asia’s stable macroeconomic environment: In terms of fundamentals, investors are rightly concerned about the credit quality of fixed-income investments in the current uncertain macroeconomic environment. We believe Asian USD bonds are arguably well positioned to navigate market volatility due to the region’s economic strength, which may help support corporate cash flows and profitability.

Indeed, the International Monetary Fund recently upgraded its growth forecast for Asia-Pacific economies to 4.6%—the highest rate among regions globally. Moreover, Mainland China and India are expected to account for roughly 50% of global growth in 2023, with the broader region accounting for around 70%. This should provide ample support for Asia’s corporates, particularly as Mainland China’s economic reopening may offer positive spillover effects to the region’s economies in varying degrees through channels such as trade and tourism.

High-quality regional companies with deep market liquidity: We believe many high-quality regional companies chose to issue USD-denominated bonds in order to reach international investors, diversify their borrowing portfolio, and tap into deeper capital markets. In addition, since these bonds are denominated in the greenback, their market fundamentals are tied to U.S. interest-rate dynamics, which are generally more stable relative to the local currency markets.

Arguably, the asset class also exhibits a high level of liquidity, particularly for emerging markets. Over the past five years, the USD bond market in Asia has surpassed US$1 trillion,¹ making it one of the most liquid fixed-income markets globally.

The asset class has a potentially lower volatility profile versus its peers: Although emerging-market debt generally possesses a volatile risk profile, Asian USD bonds, especially short duration IG bonds, may benefit from two factors that could dampen overall risk.

First, the emergence of a robust regional institutional investor base provides demand for USD-denominated bonds and can act as a potential secondary cushion for prices during risk-off periods. Indeed, between 2014 and 2022, regional investors accounted for roughly 70% of Asian USD bond allocation²—the largest buying segment of the asset class.

At the same time, should the U.S. Treasury market experience volatility due to Fed policy, the short duration focus of Asian USD-denominated IG bonds may enhance performance resilience.

Asian short duration bond profile has dampened volatility over the past decade

Source: Bloomberg, as of March 31, 2023. Returns for Asian short duration investment-grade (IG) bonds are represented by the J.P. Morgan Asia Credit (JACI) Investment Grade 1–3 Year Total Return Index. Returns for global bonds are represented by the Bloomberg Global Aggregate Bond Index. Returns for Asian bonds are represented by the JACI Composite Total Return Index. Returns for global short duration IG bonds are represented by the Bloomberg Global Aggregate 1–3 Year Bond Index. It is not possible to invest directly in an index. Past performance does not guarantee future results.

This is because shorter duration bonds are less sensitive to movements in interest rates. Asian short duration IG USD bonds traditionally have a lower duration profile than the general Asian and global bond universes. They also possess only marginally higher volatility (1.2% versus 0.9%) relative to global short duration IG bonds over the past decade. 

Historical comparable yield premium and attractive returns over peers: Historically, investors in Asian IG USD bonds have received a spread premium over those holding U.S. IG corporate debt. As of March 31, 2023, the premium was 60bps, while the average premium over the past 10 years came in at 83bps. This means that investors in Asian IG USD debt effectively receive a higher yield for holding companies with roughly the same credit profile and risk level as their peers. 

From an overall performance perspective, investors should not only pay attention to yield, but also to an asset class’s total return over time. 

• When compared with global short duration bonds: Asian short duration IG bonds have outperformed their global peers on an annualized basis for the past decade. This is supported by the relatively higher yields and coupons offered by Asian short duration IG bonds compared to global corporates. 
• When compared with bank deposits: While investors have turned to bank deposits over the past two years to shelter themselves from market volatility, the Fed’s changing monetary policy stance may put this strategy at risk. Indeed, research indicates that current USD three-month (promotional) time deposits in Singapore earn roughly 3.7% versus a yield to maturity of 5.6% for Asian short duration IG USD bonds.³

With the market’s expectation for a Fed pause to take place in the near term and potential rate cuts over the longer term, investors may face significant reinvestment risk when their deposits mature and they can only reinvest at potentially lower interest rates in the future.

Asian IG historical spread premium over U.S. IG

Source: Bloomberg, BofA Merrill Lynch, and J.P. Morgan indexes, as of March 31, 2023.

Asian short duration IG performance versus global peers

Source: Bloomberg, as of June 2022. Returns for Asian short duration investment-grade (IG) bonds arerepresented by the J.P. Morgan Asia Credit (JACI) Investment Grade 1-3 Year Total Return Index. Returns for global bonds are represented by the Bloomberg  Global Aggregate Bond Index. It is not possible to invest directly in an index. Past performance does not guarantee future results.

H2 2023 outlook: constructive on national champions, China credit

For the remainder of 2023, we’re constructive on national champions and credits in Mainland China:  

• National champions: The significant percentage of state-owned enterprises (SOEs) in the region’s IG bond market is a unique feature of the Asian IG bond universe. SOEs tend to have more stable cash flows and market positions due to their ties to the government, while offering lower volatility at attractive yields. In addition, new issuance activities from private national champions such as banks and electric vehicle battery producers have picked up in 2023, providing further opportunities.
• China credits: With Mainland China’s reopening in process, we remain constructive on the country’s credits. While we don’t expect a V-shaped economic recovery, over time, we believe the country’s reopening should support domestic companies and firms in Southeast Asia, which could benefit from a pickup in trade and tourism activities.

Conclusion

Over the past two years, investors looking to earn returns on excess cash have primarily chosen bank deposits to escape market volatility.  Moving forward, we believe that changes in the macro landscape, particularly a Fed policy pivot, may offer more profitable options.  

Asian short duration IG USD bonds offer competitive yield and may provide capital appreciation upside over the long term when rates gradually move lower. Given its relatively lower volatility profile, which is supported by the region’s l macroeconomic fundamentals, we believe investors should pay greater attention to this asset class in the current market environment.

1 The US$1 trillion market is primarily composed of IG (84%) credits, but also includes high-yield bonds (16%). 2 Manulife Investment Management, as of March 31, 2023. 3 Manulife Investment Management, as of March 31, 2023. The rate quoted applies to USD deposits exceeding US$3 million. Data cited for yield to maturity is as of March 31, 2023.