Post-Hellenic Bond Disorder
Liquidity concerns have trumped financial sense in Asia’s markets. Investors fretting about a euro breakup are diversifying into larger, more liquid bond markets like Australia’s. But it is hot money and it could burn investors when the story changes. Higher-yield bonds from say, the Philippines, might be a better bet.
The biggest beneficiary of fears about the euro is the U.S. dollar, and its related bonds. But investors don’t want to put all their eggs in the dollar basket, particularly given the United States’ own debt problems. So they are parking cash in bonds in Australia, South Korea and Japan but avoiding smaller markets like the Philippines and Indonesia.
The logic is two-fold. First, Asia’s bond markets are relatively small, so investors prefer the region’s largest. They want to avoid, if possible, pushing prices up as they pile in just as they want to minimize the risk of getting caught in an avalanche if they try to pull back out.
Secondly, Asian economic strength is built on exports. So a global slowdown is likely to force Asian central banks to cut rates to buttress growth, as Australia’s Reserve Bank just demonstrated. Lower rates raises the value of existing bonds. The spread between Australian 10-year government bonds and equivalent U.S. Treasuries has fallen by almost half a percentage point since March. The same spread on Korean bonds has climbed only 0.3 percentage points.
But while domestic demand offers protection to Japanese bonds, other markets are vulnerable to a sudden correction. Australia’s government finances are sound, but its bond market is dominated by foreign investors, and it has a high exposure to European banks. Korea has a similar weakness: high dependence on short-term borrowing from abroad. If the euro collapses, European investors could face such enormous losses they have to liquidate Asian holdings, too. And if the situation in Europe improves, they may cash out and fly home.
The Philippines has a smaller bond market and, like Japan, most bonds are owned by domestic investors. It has ample reserves and low short-term external debt, yet it is paying 6 percent. It has lots of room to cut rates should weak exports hurt growth. Investors willing to stick around may find such smaller harbours offer the safest havens.