Negative bond returns test Asian investors' mettle

HONG KONG (Reuters) - As risk appetite for equities and property wanes, investors are willing to endure negative real returns for bonds from China, Singapore and Hong Kong because their economies are seen better equipped to tackle inflation.

Conventionally, bond yields have to be sufficient to compensate investors for their holdings as inflation erodes value over time, but those seeking safe haven destinations are choosing to brave lower returns in some markets.

Bond investors are proving less patient with India, Thailand and the Philippines, markets where yields will continue to rise on worries about fiscal imbalances and authorities' limited effectiveness in overcoming inflation.

Governments in Asia are struggling to cope with double-digit inflation from rising oil and commodities prices and widening deficits, which are hitting their currencies and bonds.

"In the long run, nominal yields have to be above real GDP growth to compensate for inflation and this is not the case in many markets," said Chia Woon Khien, Royal Bank of Scotland's local markets strategist.

She named China, Singapore and Hong Kong as markets where yields are insufficient to offset inflationary erosion. But these bonds are less vulnerable than the rest to be dumped in a sell-off.

Chinese government bonds yield about 4.3 to 4.6 percent on the long end of the curve, well below the latest inflation rate of 7.7 percent, while Singapore's 7.5 percent inflation also dwarfs its long-term bond yield of 4 to 4.3 percent.

But bond yields are unlikely to rise as these countries' fiscal positions are sound and demand for government debt in the current environment remains strong.

"The real rates are still negative but the thing is there is still a flush of capital inflows and risk appetite is gone," said Zhi Ming Zhang, fixed income analyst with HSBC, referring to the slide in property and equity markets.

"The only place to park banks' money is in government bonds and that will force yields down even though yields are not high enough to compensate investors," he said.

Investors in these bond markets are also not worried about rises in official interest rates as the authorities have other inflation-fighting tools at their disposal.

"The risk premium has to rise across Asia, although it will be lower in countries where the currencies have room for appreciation, for example Singapore," said Rachana Mehta, fund manager with DBS Asset Management.

WEAK CURRENCIES

But not all Asian economies can use their currencies to tamp down inflation.

The Indian rupee has fallen 8 percent and the Philippine peso PHP=PH by 7 percent this year, after posting double-digit gains against the dollar in 2007.

Therefore, a growing number of central banks in the region will have to use the interest rate route to contain inflation and this will be particularly imperative in economies which do not have substantial current account surpluses.

With oil prices near record levels of $139 per barrel, more countries around the region are seeing a reduction in their current account surpluses. In fact, South Korea and India are likely headed toward full-year deficits this year while Thailand's current account balance turned negative in April.

"At this juncture, the stress on Asian bond markets is coming more from fiscal balances rather than inflation," said Royal Bank of Scotland strategist Chia. "In this case, I see upside risks for yields in India and Thailand."

Morgan Stanley expects Indian bond yields to jump to a seven-year peak as inflation approaches double-digits and with its fiscal deficit expected to widen this year under the strain of farm loan waivers, tax cuts and oil and farm subsidies.

"The macroeconomic environment for the long-duration government bond market is steadily deteriorating," the bank said in a report forecasting the yield on the 10-year bond could rise to as much as 9 percent from 8.4 percent by year-end.

Analysts praise the steps taken by Indonesia, the Philippines and Vietnam, three Southeast Asian economies which have aggressively raised interest rates to check inflation, but bond markets are factoring in even more monetary tightening.

Bank Indonesia raised its key interest rate by a total 50 basis points this year to 8.50 percent, and analysts expect an aggregate 75 bps to 100 bps additional rate rise for the year.

Neighbouring Philippines raised interest rates this month for the first time since 2005 as inflation hit a nine-year high.

India also surprised markets last Wednesday by raising its key lending rate for the first time in more than a year after a recent rise in state-set fuel prices.

"The bond sell-off in Indonesia and Philippines is in an advanced stage and given that central banks have started to tighten, markets will consolidate, albeit in a weak range since triggers from commodity prices remain negative," said Ashish Agrawal, local market strategist at Merrill Lynch.

(Editing by Jacqueline Wong)