Korean, and emerging market bond rally is not over yet

* Korean bonds hit tightest ever after upgrade

* Emerging market spreads may still narrow further

* Further rally in US Treasuries would add to gains

Aug 28 (IFR) - The one-notch upgrade of South Korea by Moody’s to Aa3 has driven the yields on most bonds from Seoul-based companies to their lowest levels in history. Spreads on these securities are also close to their tightest ever, even as US Treasury yields are dropping.

And while Korea is the bellwether, the move is broader. Most investment-grade bonds in Asia, with a few exceptions, are as rich as they have ever been. Still, investors are unfazed and most are betting that there still is plenty left to gain from buying into the asset class.

“All in all, I see continued demand for EM dollar assets, continued demand for investment-grade rated (benchmark) Asian and Latin American credits due to a marked lack of supply which forces benchmark-aware managers to continue deploying inflows or reinvestment flows into higher yielding securities,” said Robert Abad, portfolio manager at Western Asset Management.

Abad is not alone. Several US-based portfolio managers told IFR that they believe the rally in investment-grade EM bonds still has legs. “EM fundamentals relative to developed markets are better and valuations, in spread terms, remain higher,” said one.

The reason for being sanguine is simple: all the factors that brought Asian credits to their current standing remain in place. And Korea is the poster child of this process having been on the upgrade list at the same time as most of the developed countries in the Western world were being downgraded.

“Balance sheet strength in EM remains resilient despite two massive body blows by the US and Europe,” said Abad.

Korea, alongside most of Asia, is still growing, while Europe and the US have almost stood still since the 2008 crisis, which explains why Korean bonds are at the tightest levels in memory.

Yet investors still believe there is potential upside, given that many of them remain wide relative to similarly-rated bonds from US companies in the same sectors. There are some examples, Hyundai and Samsung for example, where companies trade in line with US peers - but investors think there could be more tightening ahead.

“The market is repricing this discount,” said the US portfolio manager.

The other factor that may prompt more spread-tightening for Asian dollar bonds is a rotation into EM fixed income. If spreads are set to tighten, yields have a lot of room to drop further, simply because the bull market in US Treasuries is yet to see the finish line, according to analysts.

In a recent research piece, US asset manager Loomis Sayles painted a dire picture of the near future in the US, as the country struggles with the so-called fiscal cliff in an election year.

In its worst case scenario - which saw US lawmakers letting massive fiscal cuts be rolled out - Loomis Sayles predicted the American economy could go into a recession and the yield on the 10-year US Treasury could drop to 1% by January.

On Monday, Citigroup analysts too predicted that 10yr yields were possibly headed to 1%, a move that would mean very significant price gains for buyers of Asian high-grade paper.

If the 2017 bonds of Korea Development Bank held on to their current spread of 150bp and the yield on the five-year US Treasury drops by 40bp, the bonds by the policy bank would rally almost US$3, or 2.8%, from their current 107.35 level.

Considering the bonds were issued in November 2011 at 99.549, then if prices breach 110 by January, investors will have logged gains of 10.5% from price appreciation alone. That is why, even when they are yielding a record low 2.3%, KDB bonds continue to be attractive.

And why there will continue to be demand for investment-grade bonds from Korea and other emerging markets in spite of record prices. (Reporting By Christopher Langner)