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* Offshore funding costs lower than local borrowing
* Rate hike views seen supporting yields
By Jongwoo Cheon
SINGAPORE, Sept 3 (Reuters) - In a classic arbitrage play, foreign investors are sweetening their returns on Philippine government bills by borrowing pesos in offshore currency derivative markets at half the rate they would pay onshore.
Emerging Asian assets have been top picks among investors as they used the cheap money flowing from major overseas central bank stimulus campaigns to buy into higher yields offered by borrowers in the Asia-Pacific region, and the Philippines has been one of the main beneficiaries.
Offshore peso interest rates are lower than onshore rates because offshore investors are holding large peso positions, betting the currency will rise on solid economic fundamentals, traders said.
This difference in the reates presents a greater opportunity for foreign investors, as central bank rules limit the amount domestic investors can borrow from the offshore market.
Investors can exchange dollars for pesos for three months at a total cost of between 0.4 and 0.8 percent via offshore currency forwards and then earn returns of 1.49 percent on three-month Philippine treasury bills .
Borrowing pesos for three months onshore costs between 1.3 percent and 1.5 percent, which would make the returns on three-month treasury bills hardly worth the effort.
Foreign investors are boosting their returns even further by borrowing pesos at the cheap one-month rate and rolling them over continuously in order to buy three-month bills, but avoiding the higher cost of three-month borrowing.
"The spread is very attractive," said Andy Ji, Asian currency strategist for Commonwealth Bank of Australia in Singapore.
Moreover, rising 1.0 percent from a 3-month low against the dollar struck on August 8 has increased the peso's appeal, which currency traders say has been boosted by demand from offshore hedge funds.
With inflation rising to a near three-year high of 4.9 percent in July there are expectations that the central bank could hike rates as early as this month.
Yields on long-term Philippine bond yields have jumped, reflecting inflation expectations. But short-term yields have risen by less and in recent weeks have even eased with the arbitrage trade.
Annual inflation in August is expected to accelerate to 5.0 percent, the upper limit of the central bank's target for the first time in nearly three years, a Reuters poll found.
Inflation puts the profitability of bonds at risk as it hurt debt prices, but the arbitrage play helped investors find higher returns in the Philippines over the short term.
"These trades are always there and may become more popular because the BSP (Bangko Sentral ng Pilipinas) has a slightly hawkish stance now," said Saktiandi Supaat, head of FX research at Maybank in Singapore.
Traders said that while sharply higher inflation could scuttle this trade by eroding the value of peso bonds, it was not yet a significant enough threat to do so. Arbitrage demand and higher rates would likely support the peso despite inflation concerns, they said. (Additional reporting by Karen Lema in MANILA; Editing by Eric Meijer)