The flight to safety began as soon as it became clear that the UK decided to leave the European Union (EU) on June 24th. Investors fled from commodities and global equities. The pound tumbled to its lowest level in 30 years. As expected, traditional safe havens like gold, the US dollar and the yen soared, while 10-year US Treasury yields fell to 1.56%, a level not seen since mid-2012.
What was perhaps more unexpected for markets was that Asian US dollar-denominated bonds also turned out to be a safe harbour amidst the Brexit storm. Traditionally viewed as a “risky asset,” Asian credit was noticeably calm post-referendum, with scarcely any signs of panic selling. The JPMorgan Asia Credit Index posted a positive total return of 0.24% on June 24th, thanks to lower US Treasury yields, which helped to offset the impact of wider credit spreads.
Source: Bloomberg, JPMorgan, 28 June 2016
There are many reasons for Asia’s resilience. One fundamental reason is that Asia’s trade links to the UK are generally small, accounting for less than 1% of GDP in most countries. Even as Standard and Poor’s stripped the UK of its AAA rating, it concluded that Brexit was largely “credit neutral” for Asian bonds. The credit rating agency was also sanguine about China’s high-yield borrowers, stating that their dollar borrowings look manageable following proactive refinancing.
From a technical standpoint, Asian bond markets have also become less vulnerable to the vagaries of international investor sentiment, thanks to the increasing proportion of local bond ownership. About 70% of new corporate issues are allocated to Asian investors today, compared to 50% two years ago. This has helped Asia trade at a lower beta than other global emerging markets. An added boon for technicals this year is that new bond supply this year has fallen substantially, largely driven by Chinese issuers converting their dollar debt to onshore yuan funding.
Over the medium term, Asia could continue to benefit from the search for yield. Already, there is increasing expectation that central banks in the developed world will trim policy rates to contain the fallout from Brexit. The US Federal Reserve’s tightening cycle, which has barely begun, looks derailed. With a yield-to-maturity of about 4.2%, Asia’s risk-adjusted returns look attractive, given the alternatives.
All this does not mean that Asia is immune to the Brexit fallout. In particular, how China reacts to renewed volatility is crucial to the health of Asian bond markets. In the near term, one key risk is that the strengthening US dollar puts pressure on the yuan and triggers another round of capital outflows. Already, an estimated US$906 billion streamed out in 2015 and capital account flows are still negative this year. One cause for cheer is that China’s central bank appears to have realised the importance of good communication for market sentiment; it released a brief statement last Friday to reassure investors that it has plans in place to withstand the shock from the Brexit vote.
More volatility will ensue in the coming months as the UK and the EU engage in political wrangling. There is also fear that other European countries would see a wave of referendums as anti-EU political parties seize the opportunity to follow in the UK’s footsteps. Ironically, Asia’s political landscape looks tame in comparison. Investors looking for safe havens would do well to take shelter in Asian hard currency debt.
Joyce Tan, portfolio specialist Asian Debt at NN Investment Partners