Negative bond returns test Asian investors' mettle

By Umesh Desai - Analysis

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.