Bonds in Emerging Asia have potential

At Barclays Wealth, we believe that local-currency government debt is an attractive way to capitalise on the improving sovereign credit outlook and robust growth potential of what we call the Emerging Asia countries. Prospective returns are supported by generally higher bond yields than in more developed countries and expected currency gains through the region.

Therefore, we suggest buying medium-term emerging-Asia government bonds, in local currencies, directly and with your currency risks unhedged. Emerging Asia, which we define as China, Indonesia, Malaysia, Singapore, South Korea and Thailand, was resilient during the recent crisis, leading the global economic recovery in both the timing and magnitude of its rebound. The region's growth was also robust prior to the crisis, expanding at a much faster pace than its "developed" peers.

In the coming years, demographics, among many other factors, are expected to support this positive growth differential. The region entered the most recent economic emergency in a position of strength, as the countries' respective governments have extensively improved their macroeconomic policies since the economic crisis of 1997-98. Our research shows that Emerging Asia sits on surplus funds, debt ratios are falling and foreign reserves are high - indeed, all of these indicators compare favourably with more advanced economies.

Reflecting the improved credit-worthiness of Emerging Asia governments, sovereign rating actions were positive last year and spreads have narrowed considerably from their peak. Given the solid and improving outlook, positive rating actions are likely to continue, which should drive spreads lower. Further tightening will also be dependent on supportive technical factors. For example, historical data show that government bond markets in the region have matured considerably, boasting extended term structures and improved liquidity.

In an environment in which US, Japanese and European yields are extremely low, Emerging Asia credits - government bonds included - are likely to benefit from incremental asset allocation. Hence, foreign capital inflows to the region have risen and should continue to do so. We consider local currency government bonds to be the most attractive way to take advantage of the improving sovereign credit outlook in Emerging Asia.

These bonds closely reflect domestic macroeconomic policies where returns are supported by potential currency gains and high carry. From an asset allocation perspective, local currency emerging market bonds also offer diversification. Although the move towards new policy standards should help Emerging Asia currencies when interest rates eventually rise, rate normalisation poses a risk to the market value of longer-dated bonds. We prefer shorter-dated bonds, specifically those maturing in the medium term. We also recommend buying such local currency government bonds directly and with the currency risks unhedged. In cases where access to local government bond markets is restricted for certain investors, bond funds or exchange-traded funds (ETFs) may be a good "second best" implementation. Within Emerging Asia, Indonesian government bonds currently offer the highest yield to maturity, and we believe this additional yield provides more than adequate compensation for the additional credit risk of buying the nation's debt. The country has achieved political stability after the elections in 2009 and the central bank has gained further credibility. The country's banking system is sound and many economic indicators such as fiscal and debt dynamics are improving. For these reasons, we deem that Indonesia is making good progress towards achieving investment-grade status - Indonesia is currently rated two notches below investment grade by Moody's and S&P, and is only an upgrade away from investment grade on Fitch's rating metrics. Emerging Asia has been resilient in the recent crisis, leading the global recovery in both timing and magnitude. Sovereign rating actions were positive last year and spreads over US Treasuries have narrowed considerably from their peak, reflecting the improved credit-worthiness of these countries and local-currency government bonds seem to be the most attractive way to take advantage of improving credit outlook. Khurram Jafree is the head of MENA investment advisory for Barclays Wealth.