Question 1 (40 marks)

Read the following article There are many opportunities in Asian bond markets, but investors will need to get discerning.

There are many opportunities in Asian bond markets, but investors will need to get discerning

Like a food connoisseur at a restaurant, Asian bond investors have an extensive menu of options to refresh their investment palates. They can opt to invest across the fixed income spectrum from hard or local currency sovereign bonds to corporate credit and the forex market. However, on closer inspection, the extensive menu masks what has been pretty bland and unappealing fare in 2018, as a function of the challenging period these markets have faced.

The Asia dollar bond market has been in turmoil, heightened geopolitics and trade tensions sapped sentiment, fears of contagion skittered across markets, defaults have punctuated the China domestic corporate bond landscape and emerging market (EM) currencies have generally slid against an ascendant U.S. dollar. Indeed, quiet dining has become a luxury. But come 2019, there are reasons to believe the menu is starting to look tastier. Meaningful pockets of value are now emerging particularly in EM Asian currencies, which are now looking temptingly cheap.

Main course: fear is easy, greed is hard

So far, 2018 has been a year in which risk aversion and defensive positioning have been the optimal strategies to protect against downside risk. But now maybe the time for investors to dip their toes back into these markets selectively. Although a difficult task, investors should think counter-cyclically. For example, the outlook for continued U.S. interest rate hikes and quantitative tightening has already pushed up bond yields, which move inversely with prices.

Rising yields equate to capital losses on bonds, but also translate into more attractive future income generation. As such, higher yields generally improve the return buffers towards fixed income and is applicable across government, credit and local currency bonds.

For example, if an investor were to purchase a corporate bond that yields 5.0% with a duration of three years, the yield on that bond could increase by as much as 1.6% before the bonds total return would be eroded to zero for the whole year. If the investor is confident in the bonds credit quality and does not believe it will default, the yield levels provide a decent buffer for the investment, even if we see a further 0.5% to 1% in U.S. interest rate increases.

la carte: Chinese government bonds the counterintuitive trade war hedge

Surprisingly, Chinese government bonds (rates) have performed well this year, undeterred by heightened trade tensions and the anxiety over the falling renminbi. Indeed, mainland Chinas bonds outperformed other Asian currency sovereign debt in the first six months of 2018 as domestic investors sought safety amid turmoil in stocks. With the tailwind of structurally greater foreign participation in the mainland China bond markets and the backdrop of accommodative monetary policy, long-term fundamentals look supportive for China rates, providing investors with a diversified income stream.

And with currency hedging costs still relatively moderate, investors have the ability to engage in rates exposure for capital gain potential and carry while mitigating forex risk. Current Chinese policy moves to provide fiscal and monetary support to protect economic growth and negate the negative impact of trade tensions suggest the outlook may be marginally brighter for credit any pause in the ongoing deleveraging campaign may contribute to easier credit conditions.

Dessert: escalating trade tensions may not be all bad

Looming tariff exchanges between China and U.S. have the potential to further impact investors come 2019. Already, one of the impacts is supply chain diversification, as manufacturers consider potential relocations to continue to serve clients and reposition their businesses. that may turn out to be a plus for some Asian economies, which have also undergone a re-pricing alongside the rest of the EM complex.

Anecdotal evidence suggests manufacturing relocation could impact a broad range of industries from textiles and semiconductors to pet-food. Although net losses for China and the U.S., such moves could have positive implications for Southeast Asian economies, who are the likely beneficiaries. For fixed income investors, this suggests interesting bond investment and local currency opportunities emerging in ASEAN.

Verdict

Although the markets volatile cycle in 2018 has led to indigestion for some investors, it is important to acknowledge that as market conditions became gradually more negative through the year, valuations have commensurately improved to reflect the growth downgrades.

In particular, Asian bond valuations have improved significantly relative to 2017, meaning investors are rewarded comparatively more to take on risk precisely because the markets expect more volatility down the road. Periods of market weakness can be opportunities to add measured risk to portfolios. In the face of continued negativity, investors should be prepared to capitalize selectively on the more attractive yield buffers.

In what is increasingly a buyers market, those who take a disciplined approach in the search for asymmetric gains in the market may be rewarded over time. We are increasingly looking for opportunities to add back risk selectively in higher yielding instruments which are mis-priced relative to their fundamentals. In other words, pick your investment palate wisely, look for good value and mull over every mouthful as being mindful has its benefits.

Source: Adapted and modified from Pang J., There are many opportunities in Asian bond markets, but investors will need to get discerning. 2018 November 15. Business Insider.

Answer the following questions:

1. There is an increasing demand for Asian corporate bonds. Referring to the article, evaluate the factors which support the booming of Asian

bonds markets. (16 marks)

2. Other than the general negative price-yield relationship, discuss the

factors that determine the yield of a bond? (16 marks)

3. Besides bond, preferred stock is also one of the sources of long-term financing. Provide TWO differences and TWO similarities between

bonds and preferred stock. (8 marks)