The beating that Asian currencies have taken in the past week will probably open up opportunities for longer-term investors to load up on local currency bonds, with the region still mostly seen as resilient to Europe's debt crisis.
Stronger fiscal positions, long-term expectations for currency appreciation and relatively high interest rates are helping some fund managers stomach a sharp selloff in Asian currencies and take a long view while investing in Asian debt markets.
Other institutional investors have joined the likes of hedge funds and slashed bets on emerging Asian currencies, even though local bond yields have held up relatively well.
Indonesian and Philippine government yields, for example, did not surge in the past month when other global markets reeled from heightened volatility, marking a sea change from a few years ago when foreigners were the first to jump ship at early signs of trouble.
Frederic Neumann, co-head of Asian economics research at HSBC in Hong Kong, said the outperformance of local debt stems from the changing composition of the investor base who display a longer investment horizon and greater staying power.
"They are unlikely to blink in the face of any short-term wobbles in global finance and it is their long breadth that has given emerging market currency and bond markets such resilience in recent weeks," Neumann said.
Even if the U.S. economy tips into a recession as some economists fear, investors believe it would only perversely end up attracting even more inflows into Asian debt as central banks pause or start rolling back some of their aggressive rate hike campaigns.
Last week alone, four central banks — Indonesia, Malaysia, the Philippines and South Korea — held rates steady citing growing uncertainty over global growth.
Then there is the growing trend of central banks looking to diversify some of their holdings away from U.S. debt and keep funds parked within Asia. The downgrade of the United States' AAA rating by Standard and Poor's last month only highlighted the contrast with Asian economies and their stronger fiscal positions, and is likely to spur even more local debt purchases by the region's central banks, awash in cash from more than $5 trillion in reserves.
In a sign of changing investor perception, sovereign credit default swap spreads of Philippines and Indonesia — both rated below investment grade — briefly traded below investment grade rated France last month.
Of course, they may yet be vulnerable to a selloff if the euro zone debt crisis culminates into a Lehman-like market seizure — a failure of a large financial institution sparking a brutal selloff across markets — but investors are showing no signs of nervousness.
To be sure, flows, prices and positioning data suggest that there may be a squeeze in long Asian positions but any sharp drop would be seen as an opportunity by institutional investors like pension funds and long-term players.
Inflows into local currency debt have consistently outstripped flows into hard currency bonds since 2010 even as allocations to equities have been volatile since then, a RBS report of EPFR data showed.
Foreign purchases of Indonesian and Malaysian debt have hit a record with overseas ownership in these markets at a third and a fifth respectively, according to government data.
The recent strength of the Chinese yuan, though not directly influencing capital flows into Asian bond markets, has had a large role in underpinning regional currencies despite the sharp volatility in equity markets.
That has given heart to investors. In China's offshore yuan bond market in Hong Kong, the Ministry of Finance sold 20 billion yuan bonds — a record for the fledgling market — to investors looking for yuan exposure in August even as the international bond market froze.
The dollar's recent strength due to safe-haven flows is unlikely to deter investors from taking a medium-term view on building exposure to Asia, even if some fast money players cash in and drive Asian currencies lower in the near term.
In a study, UBS said many of the imbalances that existed in 40-plus major emerging economies it tracks have reversed since 2009, encouraging investors to add exposure in emerging debt.
Believers in the Asian debt story have been well rewarded. In dollar terms, the JP Morgan GBI-EM local currency bond index has gained 5.3 percent so far this year compared to the MSCI index of Asia shares ex-Japan which is down 11 percent in the same period.
Emerging market stars like Indonesia and Philippines are set for their third year of double-digit returns after posting equity like performances in 2009 and 2010.
New Kids on the Block
Apart from pension and long-only funds based out of Europe, U.S. and Latin America looking to invest, sovereign players like central banks are the "new kids on the block," according to Rajeev De Mello, head of Asian fixed income at Schroders.
In recent months, China has purchased Japanese and Korean bonds, while Malaysia has quietly picked up Singapore and Indonesian debt. Of course, that doesn't mean the outlook is entirely rosy.
Inflation, a traditional bugbear for the region, is still on the boil and could trigger investor aversion as was evident in 2007/08 and for a brief period earlier this year.
Western banks could be forced to unwind their long positions in Asian assets if the festering problems in Europe morph into a full scale financial crisis, triggering liquidity shortages.
But with the retreat in commodity prices, money managers are looking to add duration. At one of India's rare auctions of debt quotas for foreign institutional investors in August, Schroders made a beeline to gain access to Asia's second biggest but among the least penetrated markets.
"The surprise is not learning something new about Asia which investors did not know six months to a year earlier but knowing something more about Europe since then and noting that the differential quality looks much better," said De Mello, who manages $6.7 billion in debt.
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