Opening markets through a bond fund: The Asian Bond Fund II

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Opening markets through a bond fund The
AsianBond Fund II

• Guonan Ma
• Bank for International Settlements
• Representative Office for Asia and the Pacific
• APEC Seminar
• Developing Asian Bond Markets from Investors
  perspective
• 4-6 November 2005, Shanghai

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The issues at stake

• What is Asian Bond Fund II (ABF2)?
• Why was ABF2 launched?
• How is ABF2 structured?
• What are the advantages of ABF2?
• How has ABF2 performed so far?

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I. What is ABF2?

• ABF2 is the second stage of the Asian Bond Fund
  (ABF) initiatives and invests in EMEAP local
  currency bond markets.
• ABF2 investment is initially funded by
  international reserves pooled from the EMEAP
  central banks.
• It complements other parallel regional
  initiatives to promote bond market development in
  Asia.

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ABF and EMEAP

• First initiatives in which a regional
  organisation has contributed financial resources
  to setting up actual bond funds in Asia.
• This organisation is a central bank forum called
  EMEAP (Executives Meeting of East Asia and
  Pacific Central Banks) with 11 members

• Reserve Bank of Australia
• The Peoples Bank of China
• Hong Kong Monetary Authority
• Bank Indonesia
• Bank of Japan
• The Bank of Korea
• Bank Negara Malaysia
• Reserve Bank of New Zealand
• Bangko Sentral ng Pilipinas
• Monetary Authority of Singapore
• Bank of Thailand

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Two stages of ABF ABF1 and ABF2

• ABF1
• launched in June 2003
• US1 billion pooled from the 11 EMEAP central
  banks only
• investing in dollar bonds issued by 8 EMEAP
  sovereign and quasi sovereign borrowers.
• ABF2
• launched in Spring 2005
• initial seed money of US2 billion by the 11
  EMEAP central banks
• investing in local-currency bonds issued by 8
  EMEAP sovereign and quasi sovereign borrowers.

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The catalyst role of ABF

• ABF1 allowed EMEAP central banks to work together
  and build trust.
• Importance of the size of the funds not so big
  as to influence markets but big enough to signal
  serious intent.
• The combined foreign reserves of the 11 EMEAP
  central banks exceed US2 trillion
• The aggregate outstanding domestic debt
  securities of the 8 EMEAP markets approach US1.4
  trillion
• RBA, BoJ and NZRB pure investors
• Process more important than size Learning by
  doing an important advantage.
• Aim of ABF2 is to reduce market impediments.

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Initiatives in Asian regional cooperation

• Various regional initiatives to promote Asian
  domestic bond markets under three banners gt
• The Asia Pacific Economic Cooperation (APEC)
• The Association of South East Asian Nations Plus
  China, Japan and Korea (ASEAN3)
• The Executives Meeting of East Asia and Pacific
  (EMEAP)
• They tend to supplement and complement each
  other.
• ABF was unique as the only initiative involving
  actual bond funds

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The role of BIS in ABF

• BIS is a cooperative organisation of central
  banks.
• BIS has been working closely with the EMEAP group
  as well as other regional central bank fora.
• Upon invitation, the BIS plays an important role
  in the ABF exercises gt
• Fund manager for ABF1
• Administrator for ABF2

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II. Why ABF2?

• Asian domestic bond markets have advanced but
  remain underdeveloped.
• Learning by doing impediments are more
  appreciated in the process of actually setting up
  bond funds.
• Market reform as a public good ABF2 accelerates
  bond market development.
• Asian local currency bonds are becoming a more
  important asset class in investors global
  portfolio.

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Domestic debt market development
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Asian bond markets advance

• Local currency bond markets in Asia has expanded
  considerably since 1998
• Total domestic debt securities of the 8 EMEAP
  markets have almost tripled.
• Domestic private debts outstanding also more than
  doubled.
• Economic consequences of the Asian crisis
  themselves added impetus to market development
• It brought home the lessons of currency mismatch
  due to a weak domestic debt market.
• Budget deficits widened amid economic
  contractions.
• Large-scale bank recapitalisation added to public
  financing needs.

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Domestic debt securities ( of GDP, 2004)

• Sources national authorities and BIS.

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but remain underdeveloped

• Despite expansion, Asian local currency bond
  markets are still well below their potential to
  intermediate.
• Capital flows show that much of financial
  intermediation is being carried out abroad gt
• Asians investing in low-yielding foreign assets
  and foreigners in higher-yielding Asian assets.
• To bring such intermediation home, Asian
  policymakers perceive a need for deeper and more
  liquid local bond markets.

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Share of non-intermediated debt( of total
domestic debt, 2004)

• Note Domestic debt is the sum of domestic debt
  securities and domestic credit. Non-intermediated
  debt is domestic debt securities.
• Sources BIS and IMF.

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Impediments to market development

• Cross-border impediments
• Capital controls and FX regulations
• Excessive regulatory hurdles to non-resident
  issuers/investors
• Cross-border delivery and settlements
• Local market impediments
• Taxes
• Regulatory fragmentations and inconsistency
• Insufficient market development
• Inadequate market infrastructure

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ABF2 Learning by doing

• Learning impediments encountered and better
  understood by policymakers in setting up of
  actual bond funds.
• Direct participation as an investor offers fresh
  perspectives.
• Doing overcoming these impediments directly by
  policymakers benefits broader market development.
• Reducing regulatory impediments can be seen as
  providing public services.
• Private-sector approach via circumventing or
  lobbying may not be the most efficient.

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Asian bonds as an asset class

• From USD, yen and euro investors perspectives,
  low correlations between an EMEAP basket and
  their home currency bond returns make a strong
  case for diversification.
• Even among components within the Asian basket,
  there is a good case for diversification via
  capital flows across the region.
• For a dollar or yen investors perspective, the
  ABF2 basket offers higher risk-adjusted returns.
• Moreover, the Asian index has higher
  risk-adjusted returns than most of its individual
  components.

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Annualised 3M USD returns of 5Y bonds over the
past five years
Source Martin Hohensee, An Introduction to
ABF2, June 2005. The EMEAP basket includes HK,
MY, PH, KR TH.
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Annualised 3M USD returns of 5Y bonds over the
past five years
Source Martin Hohensee, An Introduction to
ABF2, June 2005. The EMEAP basket includes HK,
MY, PH, KR TH.
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III. How is ABF2 structured?

• ABF2 has nine funds in two phases
• Phase One 11 EMEAP central banks invest 2bn in
  8 EMEAP markets via 9 separate private bond
  funds.
• Phase Two these 9 bond funds will be open up to
  all investors via listing in exchanges.
• All nine funds are index funds tracking
  benchmarks provided by International Index
  Company (IIC).
• One of these nine bonds funds directly covers the
  eight EMEAP markets.

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Nine bond index funds under ABF2

• ABF2 comprises nine separate bond funds
• 1 Pan-Asia Index Bond Fund (PAIF)
• 8 single-market bond index funds.
• All 9 ABF2 funds are bond index funds
• Passively managed against (tracking) benchmark
  indices
• International Index Company is the third-party
  benchmark index provider.
• So far, the PAIF, Hong Kong Fund and Malaysia
  Fund have already been listed.

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Structure of ABF2
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Two phases of ABF2

• Phase 1 investments of some 2 billion in the
  nine ABF2 funds are confined to EMEAP central
  banks (already fully operational).
• Phase 2 the nine ABF2 funds are to be
  gradually opened up to other institutional and
  retail investors, both within and outside the
  EMEAP region (so far, four funds have been listed
  on exchanges).
• A staged approach each fund could proceed at its
  own pace and timing to accommodate differences.

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More on the PAIF

• A single-index fund covering all eight EMEAP
  markets.
• Domiciled in Singapore and initially listed in
  the Hong Kong Stock Exchange.
• Quoted in USD on an unhedged basis and tracking
  the total returns of the Pan-Asia Index.
• Starting with an initial equal weight, the market
  weights of the iBoxx Pan Asia Index are
  determined by four factors
• Bond market size (20)
• Turnover (20)
• Sovereign rating (20)
• Market openness (40)

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Market weights for the PAIF
Based on market capitalisation alone
Based on four factors
Sources International Index Company (2005b,
right-hand panel) BIS calculations (left-hand
panel).
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A new family of indices by IIC (iBoxx)

• A family of Asian bond indices, known as iBoxx
  ABF, serve as the benchmarks for the ABF2 funds.
• These indices include sovereign and
  quasi-sovereign local currency debts, with the
  latter subject to credit rating criteria.
• Bond prices for index constituents are provided
  daily by leading international investment banks
  and local institutions.
• A useful addition to market infrastructure.

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Two ways to trade the PAIF
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IV. What are the advantages of ABF2?

• Market impediments were encountered in the
  setting up of ABF2
• but peer encouragement fast-tracks market
  reforms
• and promotes central bank cooperation and
  public-private sector cooperation.
• Mechanisms have been built to offer incentives to
  further reduce impediments.
• More product innovations and broader investor
  base.

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Peer encouragement to fast-trackmarket reforms

• Working as a group, EMEAP central banks benefited
  from peer encouragement gt
• Better appreciating more their divergent
  regulatory frameworks.
• Seeing that neighbouring countries have already
  instituted market reforms helps in
  fast-tracking your own initiatives.
• Central bank officials worked with their
  counterparts at the MoF or securities regulator
  to deal with impediments.
• Building confidence and rapport for central bank
  cooperation.

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Some impediments are already removed.

• Relaxing capital controls
• Malaysia announced significant measures to
  liberalise FX controls on the eve of launching
  ABF2.
• ABF2 is the first foreign institutional investor
  gaining direct access into Chinas inter-bank
  bond market.
• Withholding taxes and other taxes
• Thailand and Malaysia have already granted
  non-resident investors withholding tax exemption
• So far, five of the eight EMEAP member markets
  have offered some sort of exemptions
• In the Philippines, the documentary stamp duty
  will be removed.

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An example of public-private cooperation

• Seed money EMEAP central banks.
• Initial mandates EMEAP central banks.
• PAIF fund manager and custodian SSgA and HSBC.
• Single market funds prominent local fund
  managers.
• Index provider IIC.
• Investors ABF2 will eventually be open to retail
  or institutional investors, both within and
  outside the EMEAP.
• Administrator of EMEAP investments BIS.

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ABF2 broadens both investment menu and investor
base

• ABF2 brings new investment vehicles to local bond
  markets.
• Five of the eight single-market funds are
  expected to be exchange-listed, and another may
  join their ranks soon.
• PAIF is relatively low-cost, low-denomination and
  transparent, appealing to a broad spectrum of
  retail and institutional investors.
• PAIF is passively managed leaving open the
  possibility of active management for other asset
  managers.
• PAIF allows for diversification both into and
  across Asia in a simple and cost-efficient
  manner.

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Dynamic incentives for further reforms

• Market weights determining ABF portfolio
  allocations will be reviewed annually.
• Market openness is the single most important
  adjustment factor in market weights.
• Portfolio allocation for a particular market may
  adjust upward upon further deregulation.
• Incentives to continue reforms are thus built
  into the mechanism of ABF2 annual portfolio
  weighting reviews.

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V. How has ABF2 performed so far?

• ABF2 was first launched in March 2005.
• So far, four of the nine-fund family have been
  listed.
• Sizable investment from outside the EMEAP.
• Liquidity varies across markets and over time.

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The launch of ABF2

• ABF2 was fully launched by June 2005
• EMEAP seed money was invested in the nine funds.
• Four of the ABF2 family have been listed as ETF
• The Hong Kong Index Fund (Hong Kong, 21 June)
• The Pan Asia Index Fund (Hong Kong, 7 July, LoF)
• The Malaysia Index Fund (Kuala Lumpur, 18 July)
• The Singapore Index Fund (Singapore, 31 August)
• Work under way to list two other funds as ETF.

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Outside investment into ABF2

• The four listed funds are open to non-EMEAP
  investors.
• Interest shown by both institutional and retail
  investors.
• All four listed funds registered growth (as of
  Sept 2005)
• The PAIF 13
• The HK Index Fund 44
• The MY Index Fund 26
• The SG Index Fund 36

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ABF2 trading

• Liquidity in the secondary markets for the four
  listed funds was good initially
• but trading decline somewhat lately.
• Trading activities vary across markets.
• One way to measure market liquidity is the
  tightness of bid-ask spreads.
• The PAIF and HK Index Funds appear to be deeper
  and more liquid by this score.

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Bid-ask spread of listed ABF2 funds( of bid-ask
average)
Source Bloomberg
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Progress in ABF2

• Net asset value declined by 2 since launch
• mostly due to changing interest rate and
  currency cycles
• Higher local interest rates (ID, HK, KR and TH)
• Weaker regional currencies (ID, KR, PH and TH)
• The July renminbi move was initially a boost to
  the PAIF
• US interest rate cycle and dollar strength

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PAIF Closing NAV/unit (US)
Source State Street Global Asset Management.
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PAIF weighted average yield vs. yield on
comparable US Treasury
Sources Bloomberg SSgA.
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Summary

• ABF2 is a learning-by-doing exercise by EMEAP
  central banks through actually setting up bond
  funds investing in local-currency bond markets.
• ABF2 initially invests 2bn international
  reserves pooled from 11 EMEAP central banks in 8
  EMEAP markets and eventually will be open to all
  other investors.
• ABF2 has helped already reduce market impediments
  and built a mechanism for further market reforms.
  
• The four listed funds of the ABF2 family so far
  have grown in size, with liquidity varying across
  markets.

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If later you have questions or comments, please
email guonan.ma_at_bis.org
Thank you!