Merits of blurring the divide between emerging and developed Asia in Apac investment-grade debt
Benefits include a larger and more dynamic investment universe, enhanced returns and less volatility
TO HIKE or not to hike? As pressure mounts on the Bank of Japan (BOJ) to raise interest rates in order to slow the yen’s decline, investors are closely watching for potential new developments in Japanese monetary policy.
The central bank ended eight years of negative interest rates in March, marking a historic step towards policy normalisation. With Japan’s inclusion in the new JP Morgan Asia Credit Index (JACI) Asia Pacific Index, the BOJ’s policy actions are significant for a likely wider group of investors.
Japan is a key market in our Asia-Pacific investment grade (IG) investment universe.
While China’s property sector crisis has dominated headlines over the past few years, our earlier research on the country led us to remain cautious on some segments within China and to diversify across the Asia-Pacific region, including Japan and Australia.
The move by JP Morgan in March last year to introduce the JACI Asia Pacific Index into its JP Morgan Asia Credit family of indices further supports our approach and our conviction that the region needs to be viewed as a whole. The new index expands the coverage of the flagship JACI to include debt from Japan, Australia, New Zealand, and other Pacific countries.
Investing in the Asia-Pacific blurs the traditional divide between developed markets and emerging ones, potentially posing problems for asset allocators that still look at the universe in a more traditional – and potentially outdated – way.
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However, we see two key benefits of doing so.
A more dynamic universe
One, the addition of these markets makes for a larger and more dynamic universe.
Compared to the JACI, the JACI Asia Pacific Index expands the universe dramatically, from US$804 billion in market capitalisation to US$1.27 trillion as at Mar 31, 2024, and from 1,263 securities to 1,790.
China, which takes up a large portion of JACI at 36.9 per cent, is reduced in the JACI Asia Pacific Index to only 23.4 per cent. This makes room for Australia and Japan, which together make up 35.4 per cent.
At the same time, the new index remains very high in quality, consisting of 88.6 per cent IG bonds, compared with 85.6 per cent for the JACI.
The additional markets have the net effect of dampening volatility, as shown in the accompanying graphic.
Furthermore, the JACI Asia Pacific Index offers a slightly higher yield and lower duration than the JACI.
Portfolio benefits
The second upside is that adding Asia-Pacific IG to a global IG portfolio reduces volatility and enhances returns.
For investors currently invested only in global IG bonds, adding Asia-Pacific IG to the portfolio also helps add exposure to emerging markets – but with the relative safety provided by the presence of several developed countries.
Aside from Japan and Australia, these include markets classified as advanced economies by the International Monetary Fund, such as Hong Kong, South Korea, New Zealand and Singapore.
It is also worth noting that the overlap between global IG (using as a proxy the Bloomberg Global Aggregate Corporate Index) and Asia-Pacific IG is small.
Australia and Japan make up only 1.7 and 2.3 per cent, respectively, of the Global Aggregate Corporate Index as at Mar 31 this year. Investing in Asia-Pacific IG therefore provides more effective exposure to the two countries.
As the cherry on top, investors not only retain the same overall credit quality – the Bloomberg Global Aggregate Corporate Index averages at A2/A3, and the average for the JACI Asia Pacific Index is A3 – but they also gain additional yields from adding Asia-Pacific IG to their portfolios.
The attractive technicals of Asia-Pacific IG (with low issuance meeting growing investor demand), generally steady fundamentals, lower duration, and lower credit-spread volatility all combine to make the asset class an attractive one.
When added to an overall global IG portfolio, it helps to boost returns and lower volatility.
On Japan
BOJ governor Kazuo Ueda has emphasised a gradual approach to rate hikes, suggesting that aggressive rate increases are unlikely.
We believe any rate hike would have a marginal immediate impact, while being positive over the longer term. In Japan, we currently favour megabanks and a select number of insurance companies.
For megabanks, the valuation loss on their bond holdings resulting from policy actions should be manageable, in our view, given the low duration of their Japanese government bond holdings. They are likely to be net beneficiaries, with profits receiving a boost from the reallocation of their cash holdings to Japanese government bonds as interest rates rise.
The megabanks have kept large cash balances in anticipation of this.
We believe insurers are likely to benefit, enjoying higher investment returns given higher interest rates. Most of them have been reducing holdings of foreign bonds and switching back to domestic bonds, particularly long-dated Japanese government bonds, as the local interest rate rose, a trend we expect to continue.
Insurers’ exposures to loans or real estate have not changed materially, and they have also been prudent in taking risks.
Overall, we believe the gradual approach to tightening that Ueda has suggested will help financial institutions manage asset risk in the higher-interest-rate environment.
The writers are co-heads of Asia fixed income at PineBridge Investments
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