How Should Investors Manage FX Risk in Asia’s Fixed-Income Markets?
A recent industry survey commissioned by the ABF Pan Asia Bond Index Fund (PAIF) showed Asia Pacific-based asset managers and owners to be increasingly optimistic about the region’s fixed-income markets. Amid a more benign economic outlook, a number of solid income opportunities have emerged, feeding into this positive sentiment.
Over the next 12 months, these institutions plan to invest around 46% of their portfolios in fixed income, up from 42% currently and 37% a year ago, with Asia ex-Japan the region likely to receive the biggest share.
Optimism has risen despite the fact that trading in Asia’s sovereign bond markets involves exposure to currency risk. While traders may consider using a hedging instrument to mitigate that risk, this involves adding an unwelcome layer of complexity to their investments. Although 35% of respondents cite currency depreciation as a key concern, recession and inflation were considered more pressing. Moreover, 36% of respondents predicted that Asia would be the best-performing region, more than double the proportion (15%) that opted for second choice Japan.
Fortunately, authorities in Asia have been taking steps to de-regulate their financial markets, which has both increased the availability of onshore hedging tools and reduced transaction costs to more acceptable levels. Central banks are aware that depreciating currencies can scare off much-needed foreign investment and are consequently more willing to step in to stabilize unruly currency markets. Another positive is that more than two years after high inflation levels triggered a global interest-rate tightening cycle, fixed-income yields now offer greater protection against currency swings. As much as 41% of asset managers surveyed cite risk-adjusted yield as their primary motive for investing in bonds.
“Significantly, the currency return component is much more volatile than the fixed-income return component,” says Pin Ru Tan, Head of Asia-Pacific Rates Strategy at HSBC. “Hedging via onshore or offshore markets is available for investors to manage their currency exposure.”
The most common form of hedging instrument for Asian currencies is a Non-Deliverable Forward (NDF). NDFs facilitate transactions in less freely traded currencies, as they are always priced and settled in US dollars. Just as with a normal forward swap with developed currencies, the main determinant is the difference between the interest rates of the two currencies over a given period. As NDFs are traded globally, there is no requirement to transact in the same country as the underlying currency exposure (owing to the diverse nature of the eight members of the PAIF, there can be considerable differences between the various currency hedges, incurring significant costs).
More developed economies, such as Singapore, Hong Kong and South Korea, benefit from liquid onshore markets for both their bonds and currencies, providing a deeper pool of market makers and tighter spreads. By contrast, developing countries such as Indonesia, Malaysia and the Philippines, suffer from lower liquidity and wider spreads, although authorities are working steadily to develop onshore instruments to help promote the domestic bond markets in these countries.
“It’s all about the hedging costs,” says Owen Gallimore, Head of Asia Pacific Credit Analysis at Deutsche Bank. “It varies from country to country and investor base to investor base. You'll find a lot of peaks and troughs in demand for hedging on the back of these currency-swap costs.”
Investors have plenty of choice as to which currencies to hedge based on those prevailing costs, or whether to use one or two more liquid currencies as a proxy for their less freely traded peers. Investors who are particularly concerned about China, for example, may choose to over-hedge their exposure to the yuan, which has a number of instruments available, to mitigate any contagion effect with neighboring currencies.
Asia’s Diversity Appeals to Investors
Regional diversity is an important part of the appeal of Asia Pacific as an investment destination. Whereas Europe constitutes a solid bloc of mature economies that generally move in unison, with policy controlled by a single central bank, Asia, by contrast, is a melting pot of heterogeneous economies, each at a different point on its growth cycle, with divergent sovereign-rating outlooks, interest-rate policies, and geopolitical risk factors. While the region lacks centralized control, these conditions allow Asia Pacific-based asset managers and owners to build a well-diversified, all-weather portfolio within the region with which they are most familiar.
“The beauty of having an exposure that blends all of these different markets is that they will potentially be moving at different paces and in different directions,” says Marie Tsang, ETF Investment Strategist at State Street Global Advisors. “You get pretty good risk-adjusted returns.”
In fact, from January 2001 to June 2024, Asian bonds posted stronger risk-adjusted returns than their US counterparts1, delivering an annualized return of 4.78% versus 3.10%, while volatility was 4.59%, compared with 4.82% for US bonds. Tsang also points to the growth of fixed-income ETFs, broadening the investor base in Asia’s bond markets.
“ETF vehicles are being made available so that investors can access these bonds,” says Tsang. “It’s increasing participation, diversifying the investor base and really connecting the investors with the borrowers.”
Funds actively manage some bond ETFs, meaning they take the currency decisions as well — one thing less for asset managers and owners to worry about. In the PAIF survey, 31% of asset owners said they would invest in an actively managed ETF or mutual fund.
Meanwhile, some investors are happy to take currency risk and that comfort may stem from the growing confidence of Asian investors in their own region, implying the base currency of their portfolios need not necessarily be the US dollar.
A Close Eye on the Outlook for Local Currencies
Another factor behind increasing comfort with local currencies may be the outlook for the US dollar. Although it has strengthened steadily on the back of rising US interest rates, that trend may be about to change, with the Fed signaling its next move will be a cut. Should Asian currencies strengthen against a depreciating US dollar, returns for local currency bonds will become even more attractive.
“If we decide to buy local bonds for dollar-based strategies, we typically need a clear view on FX, over whether the local currency is appreciating or not, because it could be costly to do the hedging,” says Andy Suen, Co-Head of Asia Fixed Income and Portfolio Manager at PineBridge Investments. “If we do not have a positive view on the local currency, that will affect our decision to exposure ourselves to those bonds markets.”
“In terms of Asia local currency bonds, investors have mainly been thinking about it as a yield pick-up play,” says Kheng Siang Ng, Asia Pacific Head of Fixed Income at State Street Global Advisors. “But they're also looking at the local currency very closely.”
For investors such as PineBridge’s Suen, that is an important factor in their bond portfolio strategies.
Apart from the potential for currency appreciation, some investors see currency as a source of diversification, which may be relevant for those investors surveyed who were focused on risk-adjusted returns. For others however, the extra volatility may be a deterrent. Either way, the survey appears to conclude that Asian bonds have a lot to offer.
For more insight, read our report: ‘Unlocking opportunity in Asia fixed income’ .