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Deflation bet

11 Apr 2014 By Andy Mukherjee

The Asian bond market is sizzling. But that doesn’t mean investors are being reckless. Rather, it might reflect growing worries that the global economy is fizzling into deflation.

So far in 2014, companies and governments in the region have raised $50 billion by selling debt denominated in U.S. dollars, euro and yen. That exceeds the $49 billion they had raised in hard currency by the same point in 2013, according to data compiled by Reuters.

Strong investor appetite is evident in the mediocre returns they’re willing to accept. Sri Lanka recently sold a 5.5-year dollar bond at record low yields. Even Pakistan, which was bailed out by the International Monetary Fund last year, has borrowed $2 billion for 10 years, tapping the market after a seven-year gap.

One view is that investors are recklessly ignoring the many things that can go wrong. Some U.S. policymakers are itching to raise interest rates; Ukraine has become the flashpoint for a new Cold War; countries from Syria to Venezuela and from Turkey to Thailand have been gripped by domestic political crises. Meanwhile, China’s debt overhang is threatening to unravel, and growth is waning across emerging markets.

Yet, puzzlingly, creditors are willing to accept almost the same compensation for risks that they received a year ago. Korea Development Bank paid 62.5 basis points more than the U.S. dollar Libor in January to raise 3-year money. In March 2013, it raised debt of similar maturity with a 60 basis point spread.

But it’s equally possible that investors are worried about an even bigger risk. Anaemic private demand in the West – combined with premature monetary tightening and tight-fisted fiscal spending – could tip the global economy into deflation. If that wager turns out to be correct, the money that investors will collect when their bonds mature will buy more goods and services than today. Adjusted for inflation, returns will get a boost.

The burden of higher real interest rates will fall on companies and governments. But unless it becomes so onerous that defaults begin to soar, bond investors can profit from a deflationary world economy.


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