>Asia: Cut duration in Korea; extend in India

• Asian central banks have started to hike policy interest rates and yield curves are bear-flattening. But that does not mean investors should stay away from medium-term local-currency bonds

• A return of policy interest rates to pre-crisis levels has been fully discounted in many markets and yields on longer-term bonds will not change much this year

• All curves are so steep that buy-and-hold positions in bonds with intermediate maturities (5Y) will outperform positions in short-term debt instruments that are rolled over

• Shorter-term tactical positions in intermediate maturities are attractive in India, the Philippines and Thailand, while short maturities are the better choice in Korea, Indonesia and Malaysia

Asian central banks have started to hike policy interest rates. Malaysia was first in the region to hike policy rates on March 4, followed by India on March 19. China, Korea and Thailand are likely to follow in 2Q. For local-currency bond markets, that means that yields will be under upward pressure and benchmark yield curves will bear-flatten.

While there is no doubt that a bear market in bonds has arrived in Asia and bond yields across the term structure will be under upward pressure, fixed income investors do not have to limit themselves to short-dated notes to limit exposure to temporary price declines over the holding period. A return of policy interest rates to precrisis levels has already been discounted and there is value in intermediate maturity local-currency government bonds despite rising short rates. Indeed, yield curves are so steep at the front end that buy-and-hold positions in government bonds with intermediate maturities will outperform positions in shorter-term debt instruments
that are rolled over.

For example, Table 1 compares investments in 5Y Asian local-currency government bonds with investments in 3Y bonds that are rolled into 2Y bonds. For the two year bond investment that starts at maturity of the 3Y bond, the table shows the yield-to-maturity necessary to achieve the same total return over five years as an investment in a 5Y bond. The comparison shows that 2Y yields in three years time would have to be 130-340bps higher than today to outperform a 5Y bond purchased today and held to maturity (column H). Such a rise in 2Y yields, which already discount rate hikes, is very unlikely. Therefore, for buy-and-hold positions, the 5Y sector on the government bond curves is more attractive than the 3Y sector.

To read the full report: INTEREST RATE STRATEGY