Asia's bond markets are the largest outside the US and Europe. National markets vary enormously but most are growing rapidly, driven by huge pools of onshore liquidity and by the desire of Asian companies to plan and fund long-term. And local banks are taking an ever bigger slice of the business.

Every orchestra has a second fiddle and in Asian capital markets that role has traditionally been taken by the bond markets, modestly keeping time behind their more illustrious equity counterparts.

If the first violin has thrived, however, the second fiddle has also become an outstanding performer in its own right, and as the Asian economic engine powers forward, the bond market is required to play a leading role.

Local resources

The value of east Asia’s outstanding fixed-income debt climbed 17.2% during 2010 by October to $5110bn, representing a 1000% increase since Asian governments set about building a reliable local resource following the 1997 regional financial crisis.

Asia now boasts the biggest bond market outside the US and Europe, more than twice the size of its Latin American counterpart and accounting for about 7% of the global total.

The market is dominated by local-currency issuance, which is about 20 times the size of the dollar market and supported by huge cash holdings in export-driven economies from South Korea to Indonesia and the Philippines.

"The key theme for Asian local-currency markets is the massive amount of liquidity available onshore," says Florian Schmidt, managing director and head of debt capital markets for Asia at ING Bank in Singapore. "This has driven issuance, encouraged the emergence of new products and fuelled liquidity, at least at sovereign level."

Governments account for the largest share of the Asian local-currency bond market, for some 70% of bonds outstanding, and the Chinese local-currency space alone is worth $2800bn, according to the Asian Development Bank. The fastest growth, however, comes from the corporate sector, which posted a 25% rise in outstandings last year, fuelled by international investors moving away from low interest-rate environments in Europe and the US and toward the faster-growing economies of the East. The move paid off: Asian investment-grade securities posted total returns of more than 10% in 2010, while high-yield ones generated profits of 17%, according to Morgan Stanley.

Moreover, bonds are starting to replace loans as the funding source of choice, with many large corporates recalibrating their funding mix over recent years. In 2010, while bond markets posted record increases, outstanding loans among blue chips actually shrank. The preference for bond issuance is not primarily about cost – loan markets remain competitive – but rather reflects a secular move away from short-term funding.

“Local-currency bond markets are thriving as capital markets continue to develop,” says Henrik Raber, global head of debt capital markets at Standard Chartered. “Whereas loans tend to run up to three years, bond markets can offer term capital out to 10 years or beyond, which suits those companies planning for the longer term.”

The fastest-growing corporate bond markets at the end of September were China and Indonesia, both of which expanded 10.9% on a quarter-on-quarter basis, boosted by bond sales from mining companies such as Adaro and Indika Energy, and property developers such as Country Garden. Singapore's corporate market also grew sharply, increasing 7.1% quarter on quarter.

The longer-term dynamics of Asian corporate culture currently mitigate in favour of bond issuance. Conservative balance-sheet management, maturity profile extension and conservation of free cashflow have become the norm, and cash to short-term debt is at an all-time high.

In the last quarter of 2010, 87% of Asian investment-grade corporate and 70% of high-yield corporate were deleveraging, according to Morgan Stanley. Top-rated Asian companies are now, on average, pre-funded all the way out to 2014, with high-yield funded to 2013.

The wider picture

Still, amid all of the hype, it is easy to forget that the national bond picture is considerably more complex than the regional whole. While some markets operate according to international Eurobond standards, others are considerably behind the curve, and often burdened by excruciating regulatory and tax regimes.

“The market varies from country to country and each is at a different stage of development,” says Jon Pratt, managing director, head of Asia debt capital markets, excluding Japan and Australia, at Barclays Capital. “In [South] Korea there is a very robust market with strong regulation and Malaysia has a large bond market relative to the size of the economy, but other countries are less developed and are mainly driven by government issuance.”

Another key issue for foreign investors is access. As export-led Asian economies grow, a priority for monetary authorities is to control inflows, and capital controls and withholding taxes are a barrier to the internationalisation of some local-currency markets. With inflationary pressure building in recent months, this has become even more of a priority.

Size of emerging east Asian local-currency bond markets

“Some markets such as Hong Kong and Singapore are fully open, but others are much more difficult,” says Stephen Williams, head of debt capital markets for Asia-Pacific at HSBC. “It’s not very easy, for example, to get into Indian rupees or South Korean won, and to do so you need to be willing to drill down into the rules and regulations.”

Until recent years, India had an almost total ban on foreign ownership of domestic bonds, capping the amount non-Indian investors could hold to just a few billion dollars. With infrastructure projects proliferating, the government has gradually relaxed the cap, but foreign ownership is still limited to $10bn for government bonds and $20bn for corporate securities. Furthermore, there is a strict requirement that investments must be in bonds maturing in more than five years and issued by companies in the infrastructure sector.

Elsewhere, Thailand introduced a 15% withholding tax on foreign holdings of bonds in October as it tried to curb inflows of so-called hot money that had pushed the baht to its highest level for more than 13 years.

That move came at the same time as rumoured currency market interventions by the South Korean authorities, seen as an effort to dampen the appreciation of the won, and led to speculation over similar manipulations in India and Philippines. In recent weeks, Taiwan's central bank said it would strictly control currency supply as part of a government effort to dampen inflation.

Global interest

The restrictive impact of withholding taxes and currency controls has raised concerns that Asian local-currency bond markets are unlikely any time soon to fully open up to international participants. However, countries including China and the Philippines have made efforts to tackle the problem by issuing local-currency bonds settled in dollars.

In September, the Philippines sold $1bn of peso bonds as it sought to cut funding costs and attract international investors to its appreciating currency, without exposure to local regulation and taxation. Interest and principal payments on the deal are linked to the performance of the peso against the dollar, but all the cashflows are settled in dollars. Bookrunners including Citi and Deutsche Bank received some $13.5bn of orders for the bond, split almost equally between Asia, Europe and the US. 

“International interest is huge because local central bank concern over inflationary pressures means it is hard for foreign investors to get access to local bond markets,” says Barclays' Mr Pratt.  “As well as the improving credit story, it is also the ideal way for investors to get exposure to rising Asian currencies.”

While international banks were well represented on the Philippine global deal, they have not had things all their own way in domestic markets, where local banks used the uncertainty engendered by the financial crisis to reassert historical relationships and build market share.

Asian domestic banks had about 50% of the local-currency bond market by the end of 2009, compared with as little of 16% in 2007, according to research firm Greenwich Associates. The international banks that did best at holding their ground were those with strong local franchises, while others lost market share to providers including Bank of China and India’s ICICI.

“It’s fairly easy for the international banks to get on board the dollar deals, but in terms of local currency, there are only a couple of global banks that are in any sense active,” says HSBC’s Mr Williams. “Still, the local-currency markets came of age during the financial crisis and there has been enormous growth in the number and size of what [deals] can get done.”

Still, some geographies represent a closed door for international banks. South Korea, for example, has a bigger local-currency bond market than Singapore, Thailand, Vietnam, Indonesia, Malaysia and the Philippines combined, but national banks have a virtual stranglehold on origination.

As banks fight for market share, the macro environment is developing. Following a period of strong spread tightening, local-currency bond markets in Asia sold off in January, amid concern over accelerating inflation and efforts to weaken local currencies.

“We have seen some of the inflows reversing in recent weeks,” says Standard Chartered’s Mr Raber. “It is not clear whether this is the first sign of money moving out of emerging markets and back to the West, but it’s probably just a short-term rebalancing.”

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