Out of the 1990s Asian Crisis, a New Bond Market Rises

Local currency sovereign bonds transfer risk from issuer to buyer

How are investors compensated for the joint risk of credit default and currency devaluation in sovereign bonds, particularly in a relatively new market?

That’s a challenge taken up in a working paper by UCLA Anderson’s Mikhail Chernov, Notre Dame’s Drew Creal and the Bank for International Settlements’ Peter Hördahl. Their research centers on a relatively new bond market: local currency sovereign bonds in Asia Pacific, which yield a hefty premium over U.S. sovereign bonds. The researchers evaluate risk premiums and determine which variables are important in explaining the risk. This work enables them to determine whether or not these bonds present an attractive risk-reward payoff.

While sovereign bonds have existed in Asia for a long time, the local currency-denominated sovereign bond market expanded rapidly as a result of the 1997–98 financial crisis in which many Asian countries struggled, as a result of collapsing exchange rates, to repay their short-term borrowing in foreign currencies. When the Thai Baht plunged more than 50% from July 1997 to January 1998, payments on the country’s Japanese yen, U.S. dollar and German mark (pre-euro) denominated liabilities grew by a like measure. Shifting to local currency-denominated bonds transfers currency risk to foreign currency-based bond investors and away from the issuer.

Since the crisis, Asian governments put in place policies to build bond markets in their local currencies, propelling local currency government bond markets in Asia to grow from less than $250 million in 1995 to $10.1 trillion (China’s $7 trillion included) in 2018. In comparison, the U.S. government bond market totaled around $16 trillion.

Chernov, Creal and Hördahl focus on the local currency sovereign bonds in Indonesia, Korea, Malaysia and Thailand. These four markets can be seen as representative of the region, and their bond markets are liquid enough to study while also open to foreign institutional investors. Another feature of these markets important to the researchers is that the exchange rates in these countries are also somewhat flexible. U.S. and Chinese government bonds are used as benchmarks to compare with these Asia Pacific local currency sovereign bonds.

Of the four countries, Korea’s local currency sovereign bond market is the largest, with Korean won-denominated sovereign bonds totaling $668 billion at the end of 2018 and a rating of AA by rating agency Standard & Poor’s at that time. The Malaysian, Thai and Indonesian local currency bond markets were each valued at around $170 billion during the same period. Their bond ratings at that time were A- (Malaysia), BBB+ (Thailand) and BBB- (Indonesia). The only rating that has changed since the end of 2018 is Indonesia’s, which rose to BBB from BBB-. Indonesia is also notable in that both its bond yields and currency show the highest volatility among the four countries. Malaysia’s yields have the lowest volatility.

Local currency sovereign bond prices provide information on both the credit and currency risks that U.S. dollar-based investors incur in these markets. In order to separate the default and currency risks, a zero-coupon USD yield was constructed for each country using a combination of U.S. Treasury bond yields and credit default swap (CDS) premiums for the Asia Pacific countries. A credit factor needed to be constructed for each country, too. Significant global and local variables in modeling Asia Pacific credit factors were found to include U.S. and Chinese interest rates, and local depreciation rates.

The researchers see strong interactions between credit and currency risks, and with these findings they provide evidence of how financial markets price the joint risk of the sovereign bonds’ defaulting and the currency’s devaluating. Default and devaluation are known as the “Twin Ds” in economics.

The Twin Ds’ risk premiums (a compensation to investors for taking greater risk than investing in risk-free assets, typically U.S. Treasuries) for the Asian bonds are large even during expansions. They range between a half and two times the U.S. bond risk premiums, depending on maturity, and compensate for local credit and currency risk that cannot be diversified. Those risks are well-compensated and translate to a higher risk-adjusted return for investors in Asia Pacific’s local currency sovereign bonds, the authors suggest. Comparing portfolios of just global sovereign bonds (U.S. and China) with portfolios of global bonds and Asian Pacific local currency sovereign bonds, the researchers find that including local currency debt more than doubles the maximum Sharpe ratio (a measure of risk-adjusted return), as compared to the portfolio holding only global bonds.