By Umesh Desai and Saikat Chatterjee
HONG KONG (Reuters) - Fiscal prudence is starting to bite some Asian governments as they find global investors are shunning longer tenor bonds, worried about a turn in U.S. monetary policy and the region's growth prospects.
Egged on by the multi-year plunge in global yields and an insatiable appetite among investors for bonds, governments in the Philippines, Indonesia and elsewhere have embarked on a strategy of lengthening the average maturity of their debt.
To do that, they issued more longer tenor bonds and swapped some of their shorter-maturity bonds for longer ones.
Unfortunately for these governments and other long-term issuers, this strategy may be starting to hurt investors.
The U.S. Federal Reserve has hinted it will soon end what has been a four-year policy of flooding markets with cheap cash. U.S. Treasury yields have climbed in anticipation of that policy tightening and bonds across emerging markets are being sold.
Ten-year treasury yields have risen 110 basis points since May.
Those investors who either have to stay in bonds or want to hold some are cutting duration, meaning they are reducing the average maturity of bonds weighted for interest payments, so that their losses in a bond market selloff are limited.
And that has led to a host of problems for both parties.
Governments have cut back on issuing at the shorter end of the maturity curve that typically attracts speculative hot money, only to find that longer-term yields have risen as foreigners sell out.
Foreign investors have struggled to find bonds with a shorter duration, and the lack of deep derivatives markets has made hedging more difficult.
"While the lack of short-term debt discourages fast-money type players, they also pose a problem for funds to hedge their bond portfolios, especially in high-beta markets where the swap market is not very developed," said Kenneth Akintewe, a fund manager at Aberdeen Asset Management Asia. Akintewe is part of a team overseeing $318 billion in assets.
The impact is being felt across yield curves, most notably in Malaysia, where nearly half of outstanding government debt is held by foreigners.
Malaysia bonds due in 2033 sold in April at a yield of 3.8 percent. They have now been sold off heavily, pushing yields up to 4.21 percent.
Meanwhile, shorter-term ringgit bonds due in 2020 and sold in July for a yield of 3.9 percent have been in demand even after the sovereign ratings outlook was downgraded by Fitch Ratings. They now trade at 3.77 percent.
Indonesia, which returned to international bond markets in 2004 for the first time since the 1997/98 crisis with a 10-year bond, has been gradually increasing the tenor of its offerings. It has issued 30-year bonds almost every year since then.
Weakness in emerging market currencies, triggered by the Fed tapering fears, is adding to the pressure and duration concners in both local and global bonds issued in Asia.
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Bear steepening in Malaysian local bonds http://r.reuters.com/xyg42v
Volatility in markets waning http://r.reuters.com/wah42v
DURATION HEDGING
In separate surveys, U.S. money manager T. Rowe Price and Greenwich Associates found that the biggest concern for institutional fixed income investors was how to reduce duration risk or average maturities in bond portfolios.
Shortening duration by selling longer tenor bonds and investing in shorter maturities remained the most popular option despite the inefficiencies in regional markets, said Michele Barlow, head of Asia-Pacific credit and convertible bonds research with BofA Merrill Lynch.
Some are opting to manage risks by investing in lower rated bonds so a bigger yield can cushion them in a selloff. But such migration, particularly at a time of an economic slowdown, is not without risks, analysts warn.
"Initially everyone thought it was a U.S. rate story," said Dilip Shahani, HSBC's Hong Kong based head of global research. "But since then, the Asian macro conditions have deteriorated which is having an impact on corporate and banks fundamentals."
Shahani recommends investing in bonds in the Chinese property sector, but prefers those rated B over a higher rated BB because the additional yield would provide a buffer against U.S. rate volatility.
Some fund managers are increasing their cash balances while "fast money" hedge funds have massively shrunk their books rather than risk underperformance.
One credit analyst estimated that bond funds had on average trebled their cash positions to 10 percent of their portfolio since the start of the year.
The flipside of such conservative strategies has been a sharp rise in longer term yields, steeper yield curves and therefore potential opportunity losses for investors, were the Fed to be less aggressive than assumed in withdrawing stimulus.
In Indonesia, the gap between the 10-year and one-year bond yields has risen to 110 basis points from 80 bps at the end of June. In neighbouring Malaysia, the gap between one- and 10-year yields is 92 bps, up from 75 bps in June.
"If the yield curve is very steep, there is a lot of carry investors are giving up," said Rajeev De Mello, head of Asian fixed income at Schroders.
"If you have shorted 10-year bonds and nothing happens in three months, you lose yield and the steep yield curve results in a valuation loss."
That is possibly why some large institutions and hedge funds reckon the market has gone too far in cutting duration and see opportunities there.
"Some of the smaller markets like Indonesia and property names bore the brunt of this, but now investors are looking to opportunistically extend duration," said a Hong Kong based local currency rates flow trader with a European bank.
(Editing by Vidya Ranganathan & Kim Coghill)
