Investing in Asia’s Local Currency Debt Markets Presentation to the Asia-Pacific Finance & Development Centre, 4 -6 November 2005 Woon-Khien. Chia@ubs. com Tel: +852 2971 6425 ANALYST CERTIFICATION AND REQUIRED DISCLOSURES AT THE END OF THE DOCUMENT UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
Content I. Overview Ø Ø II. Evolution – after shocks from 1997 crisis Features – size, liquidity, credit risk, openness (ABF 2 weights) Building blocks Ø Ø Ø Policy setting – targets and objectives Regulatory issues – tax, custodian, settlement Market instruments – funding, investing, hedging and benchmarking III. Investor base Ø Ø Governments, quasi-govt agencies and multinational agencies Local, largely long-term, investors Foreign real money managers Short-term foreign investors IV. Investment strategies Ø Ø Different motives => different strategies <= different advice Benchmarking performance 1
I: Overview – market evolution Prior to 1997 Region of high growth- high inflation Monetary policies supported pegged/ quasi pegged currencies Fiscal policies supported social programs Post 1997 Growth & inflation moderated MP: from monetary to inflation targets FP: austerity, privatisation & debt restructuring Local investors’ choice – fixed deposits or equities (bonds didn’t feature) More liquid money markets Foreign investors were mainly into short-term FX carry trades More diversity in issuers & therefore, investors Deeper bond markets 2
I: Overview – aftermath of 1997 Outstanding Domestic Debt Outstanding Foreign Debt as % of Total Outstanding Source: ADB 3
I: Overview – not quite a level playing field i. Boxx ABF Pan-Asia Index Source: Indexco ØCollecting hard data like market size and turnover was not a straight forward task. ØComparing market openness across the region was the toughest judgment call. ØThe end result was a set of allocation weights which are far from an allocation based on pure market capitalization. 4
II: Building blocks – policy setting ØOne of the biggest post-crisis policy change is in exchange rate management. ØInitial switch into floating regime was guarded by capital and FX controls. ØToday, although capital controls have been mostly lifted, FX controls remain. ØMonetary policies were also switched from monetary targeting to interest rate targeting. ØThis has indirectly helped in promoting growth of the domestic bond markets. 5
II: Building Blocks – market instruments ØMost jurisdictions do not provide non-residents with access to onshore markets for funding or hedging their bond investments. ØExcept for Korea, bond indices are either not available or not well developed if available, whether for benchmarking or investing. ØAs a result, non-resident investors usually have to rely on offshore non-deliverable markets to hedge their risk, which at most times, is only adequate for hedging FX and not interest rate risk. 6
III: Investor Base ØThree types of (non-issuer) investors ØLocal long-term “buy-and-hold” investors e. g. pension funds ØMake up 70 -95% of local private non-bank investor base ØHorizon: 6 M – 5 Y ØMotives: yield enhancement, liability matching ØForeign real money managers ØHorizon: 3 M – 12 M ØMotives: FX gains, yield carry ØForeign short-term investors e. g. hedge funds ØInitially only bank’ proprietary desks & corporate treasuries… now institutionalized hedge funds, # from 0 to 100+ in 5 years ØHorizon: 1 D – 3 M ØMotives: Zero-cost macro trades, positive carry arbitrage trades 7
IV: Investment Strategies – case study ØMacro call ØBank of Korea stands pat at its next policy meeting. ØMarket response ØInterest rates to ease, yield curve to bull-flatten, volatility to dip ØInvestment strategies ØLocal investors – extend duration ØForeign real money managers – extend duration, hedge FX risk. ØHedge funds – look for arbitrage opportunities with underlying motives to long rates or flatteners outright or through swaptions. 8
IV: Investment Strategies – BOK policy setting In 1999, BOK switched from monetary to interest rate targeting, independent of the Fed. 9
IV: Investment Strategies – real money managers ØKTBs have sold off since August in anticipation of aggressive rate hikes by BOK. ØReal money fund managers’ investment decision is how much duration risk to take weighing between cash and bonds. ØCost of funds is implicitly the 3 m CD rate for local investors and the 3 m Libor rate foreign investors. ØIdeal performance benchmark is a domestic bond index. 10
IV: Investment Strategies – hedge funds Advice a hedge fund would need ØDirection on interest rates ØCorrelation analyses e. g. correlation between swap rates and curves => directionality of the swap curve Likely Curve Moves Bear Steepening Today’s curve Bull Flattening Unlikely Curve Moves Bear Flattening Today’s curve Bull Steepening 11
IV: Investment Strategies – hedge funds Conditional curve flatteners ØNo FX exposure and can be structured as zero cost ØTargets absolute return Zero Payout… Options are Out of the Money Sell Receiver Swaption (or Bond Call) Lose $ Buy Receiver Swaption (or Bond Call) Make $ $ $ 12
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