Investors Are Pouring Billions Into Emerging Asia's Lowest-Yielding Bonds

Emerging-Asia investors are betting lower-yielding bonds are set to outperform -- and with good reason.

A study of two of the region's lowest-yielding markets -- South Korea and Thailand -- and two of the highest -- Indonesia and India -- reveal the former lured in vastly more funds last quarter, and they also offered wider spreads over U.S. Treasuries compared with their historical averages.

The preference appears to make sense given that the Federal Reserve has flagged it is on the road toward cutting back on bond purchases in coming months, a move that threatens to have a greater negative impact on riskier, higher-yielding debt in places such as India and Indonesia.

Emerging Asia's favorite in the second quarter was Korea, which saw net inflows climb to a record $33 billion, boosting this year's total to $62 billion. Thailand attracted more than $2.4 billion, the most since the third quarter of 2018. Indonesia saw net inflows of $2.5 billion, while India was hit by outflows of $1.1 billion.

The ranking of inflows closely corresponds with the level of spreads versus their historical averages. South Korea's 10-year bonds offer a yield premium of 62 basis points over similar-maturity Treasuries, an amount that equates with a z score -- or number of standard deviations from the five-year average -- of 1.3. Thailand's debt, with a yield premium of 29 basis points, has a z score of 0.53.

At the other end of the spectrum, Indonesia's 10-year debt offers a spread of 512 basis points over U.S. yields but that is 0.10 standard deviations lower than the five-year average. India's 10-year yield premium is 458 basis points, but the z score is minus 0.6.

South Korea's three-year yields jumped by 21 basis points in June alone as traders moved to price in a quicker pace of interest-rate hikes due to accelerating economic growth and inflation. Dollar-based investors who buy Korea's three-year bonds and hedge via cross-currency swaps can earn a pick-up of around 90 basis points over similar-maturity Treasuries.

"There is definitely a merit in investing in Korean bonds versus Treasuries, now that the yield gap between the two has widened even more within a short period," said Lee Mi Seon, an analyst at Hana Financial Investment Co. in Seoul. "Inflows are expected to continue for the time being as U.S. short-term yields are likely to stay low at least until the Fed starts to raise interest rates too."

While a number of emerging-Asian yield differentials look attractive, countries in South and Southeast Asia in particular may need to make progress in combating the pandemic before fund flows return. Indonesia has announced record daily numbers of new Covid-19 cases in recent days, with President Jokowi announcing "emergency curbs" on Thursday in the economic centers of Java and Bali.

"For Indonesia and India, investors are stuck between multiple conflicting forces including a hunt for yield, Covid-19 worries and Fed taper concerns," said Eugene Leow, fixed-income strategist at DBS Group Holdings Ltd. in Singapore. Ultimately, investors may return in a big way later this year when there is greater clarity over the pandemic, he said.