Southeast Asia’s bond rally is over

Southeast Asia's bond market may be flashing warning signs that the region's riskon rally has run its course. After soaring this summer, the region's bond yields enjoyed an impressive recovery following the Fed's decision in September against raising rates. That and weak job numbers in the United States triggered a revival in appetite among global investors for emerging markets.

Yields on 10-year Philippine government bonds have dropped to 3.7% from 3.8% at the end of September, while Indonesian 10-year yields have fallen to 8.8% from 9.8%. The most dramatic rally, however, has been in Thailand, where 10-year government bond yields have dropped to just 2.65% from 3.1%.

But that rally appears to be running aground on the region's rocky realities, including weak global demand for the exports, volatile oil prices and domestic political uncertainty. That may mean that investors should not only stop piling into Southeast Asian bonds, but also take a hard look at their exposure to the region's stock markets.

There is still a case for buying Southeast Asian bonds, particularly for local investors. Slowing regional growth means central banks are still looking for opportunities to cut interest rates. While the Philippine central bank is likely to stay on hold, Morgan Stanley predicts that over the next year Thailand's will cut its benchmark rate by 0.25 percent points to 1.25% and Indonesia's by 0.5 percentage points to 7%.

Morgan's Asian credit strategists Kelvin Pang and Justin Kung point out that Asian companies with enough cash are buying back their foreign-currency bonds for the first time since the global financial crisis. That makes sense: with local rates headed lower and markets still anticipating a rate hike by the US Federal Reserve early next year, companies will be able to borrow more cheaply at home and avoid the risk Asian currencies resume this summer's slide. That's reducing the supply of dollar-denominated Asian corporate debt, which helps offset the negative impact of rising debtservicing costs.

Whether you're holding Southeast Asian bonds or stocks, what should concern you is that companies appear to agree with economists that the region's currencies have further to fall. That's obviously bad for foreign investors holding local- currency debt, but also stands to hurt dollar-denominated bonds by raising the cost to companies of servicing the debt. The greater risk of defaults augurs ill for stocks, too.

One reason for the renewed pessimism, according to analysts at Markit, is uncertainty over oil. While prices for Brent have steadied around $48 a barrel, nerves have been on edge since the end of August, when Saudi Arabia suggested it was ready to respond to Venezuela's calls for an emergency meeting of OPEC and Russia to curtail record production. Traders worry prices may soon break one way or the other. Higher prices would be good for Indonesia, but bad for Thailand and the Philippines, and vice versa.

Indonesia's 8.8% yield might still look tempting, therefore, but with currency risk still so high, Jakarta's bonds aren't worth the cost of hedging it. While the rupiah has soared 9.3% against the dollar since the end of September, Indonesia's current account deficit and relatively high levels of foreign debt leave it particularly vulnerable to any reversal in global investors' appetite for risk.

Jakarta is also falling short on tax revenue. Tax officials recently revealed they had managed to collect only 53% of the budgeted target by the end of September. Indonesia tends to fall short on spending, too, but that revenue shortfall raises the risk of a budget deficit blowout.

The Philippines offers a harbor of relative fiscal calm, but yields on its debt are also too low to justify the cost of hedging against declines by the peso. Stocks in Manila offer a better deal, but at 19 times projected earnings look too expensive to bother.

The same is true in Thailand: Thai bond yields have been driven so low by domestic investors that stocks look more attractive. Thai stocks are trading at just 15 times projected earnings and pay dividends yielding 3.2%.

That would make Thai stocks look cheap if it weren't for the country's continued political risk. Almost a yearand-a-half since taking power in a coup, Thailand's military junta still lacks the political power to revive growth or to push through a new constitution in order to hold democratic elections.

Thai stocks, which have after falling roughly 10% this year, have rebounded by 5% since September, and investors optimistic Thailand's turmoil is behind it should consider iShares MSCI Thailand Capped ETF, which is trading at a discount to its net asset value. But that discount seems to reflect the very real risk that things in Thailand get worse or simply fail to get better. Comments? E-mail us at wayne.arnold@barrons. com