Credit Spreads on EMB II 新興市場債券的利差 II

4. Explanation

To explain the situation that the EMB credit spread increase recently after the decline in the past four years, we can look into the emerging market economy developments as well as the keen carry-trade activities.

People may wonder why the credit spread still decline during the past four years when US FED rate was kept rising (June 2003- June 2006)(see Table A). It is because 1^st) Japan Yen was kept as zero rate during that period, much global investors simply do “Yen carry trade” as mentioned above instead of using US dollar directly; 2^nd) The Good Economic factor (which pushes the credit spread down) in emerging market during the past four years dominated the US interest rate factor(which pushes spread up).

In year 2003, Jim O’Neil, Goldman Sachs delivers a report which pointed that Brazil, Russia, India and China (BRIC) would have a great potential to grow rapidly and become the four most dominant economies by 2041.Since this thesis was released, many foreign investors and institution get interested in invest in these emerging markets. Today, different economic data show that the main emerging markets really record great improvement in the past few years. According to IMF World Economic Outlook 2006, the emerging market countries achieved a total real growth rate of 7.2% while the advanced economies’ GDP increased by only 2.7% in 2005.This good economic prospect in the emerging market boost up their bond investment activities, therefore credit spread decline in the last four years.

However, the situation changed recently when BoJ on 14 July 2006 edged up its target overnight rate to 0.25 percent from effectively zero, where it had sat for most of the last seven years.

Since Japan Interest rate increases, the cost of yen carry-trade increases. The global investors therefore reacted with this sad news, and reserved some of their trade immediately. As mentioned by the Economists, those emerging market bonds which depend on mainly foreign investors can only further increase their rate in order to maintain their competitiveness.

Deutsche Economist, Spencer wrote in a research note that Indian, Indonesian and Malaysian assets are "probably most vulnerable to an unwind of carry trades."

With the even greater increase in EMB yield, as a result of Yen interest rate increase, the EMB credit spread have recently risen. As the concern of BoJ's further action on increasing rate still surrounds the market, the credit spread of EMB is expected to be kept in a high level.

Conclusion

The emerging market bonds which heavily depend on the foreign investors, not only would be affected by the local economy and interest rate factors, but also the liquidity, foreign interest rate and foreign economy matters.

In the past four years, the emerging market faced a bloom economic growth; investment activities increased, and thus credit spread declined as the economy factor (which lower down the credit spread) dominated the interest rate factor (which boost up spread) .

When the bank of Japan started to increase interest rate on July 2006, situations changed. As originally a lot of global was doing “yen carry-trade” on emerging market, increase in Japan yen interest rate (which now becomes the dominant factor) forced the emerging market yield increase. And therefore, emerging market spread has risen recently after the decline in almost past four years.

Credit Spreads on EMB I 新興市場債券的利差 I

Introduction

-----------------------------------------------Abstract----------------------------------------------

A recent article in The Economist argued that, "Emerging economies that depend heavily on the whims of foreign investors to keep themselves afloat will find it very tough to compete, which is why emerging debt under performs when rates rise…" The author of this paper agrees with this point of view explains why credit spreads on emerging market bonds have recently risen after declining for most of the last four years. This paper elaborates the main factors that would affect emerging market credit spread and further explains the situation the emerging market facing recently.

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It was well-known that the borrowing cost or the yield of the emerging market bonds (EMB) is greatly influenced by global factors. These factors include interest rate risk, default risk, liquidity risk, exchange rate risk, economy expectation. All factors would directly and indirectly lead to the change in credit spread of the emerging economies. This paper would mainly concentrate on the idea of the mentioned article in the Economist and analyze on influence of the interest rate factor .Moreover, the paper would discuss the effect of carry-trade on the emerging market.

To understand the recent EMB credit spread, the plan of this paper is organized into a reader-friendly flow. In the first section, it reviews the meaning of credit spread and talks about the recent trend on the credit spread. In second section, it presents a number of possible factors that would interact with the emerging market credit spread. In the third and fourth session, it brings a focus into the carry-trade activities on the emerging market and derives an explanation to the current situation.

Analysis

1.      Meaning of Credit Spread and Recent Trend of the EMB credit spread

Credit spreads are defined as the difference between the annualized yield of the EMB and annualized yield on the industrial country government bond of the same currency denomination and maturity. This difference in interest rate reflects the credit risk difference between the two bonds. The greater the credit risk (the lower the credit quality) of the high yield bond compared to the low yield bond, the larger the spread.

According to the recent data, it was shown that the credit spread of EMB has recently risen. Below graphs (Fig. A and B) are examples showing the credit spread between emerging market with respect to yield of developed counties. And similar trends were found in other EMB, too.

2. Possible factors affecting the spread

a) Default Risk: This is the risk that the debt issuer has not met its legal obligations according to the debt contract. The greater default risk the bond has, the greater its credit spread.

b) Liquidity risk: Liquidity risk usually occurs in the market with low trading volume. To compensate this risk, investors would ask higher yield (higher required return), therefore great spread.

c) Exchange rate risk: Due to the globalization, bond trading nowadays is not only fixed to local investors. Many EMB, such as Philippine government bond, are issued in USD. As there is a currency different, global issuers and investors have to bear the exchange rate risk. For those with higher exchange rate fluctuation, there is higher exchange risk and therefore greater credit spread.

d) Interest rate risk: It is the risk that bond price decrease due to increase in interest rate. If foreign interest rate increases, the attractiveness of EMB would decrease. To maintain its competitiveness, investors would ask for an even greater increase in yield of EMB. As a result, credit spread increases.

e) Economic Activities: Global investors would be attracted to regions with good economic prospect as there would be less default or liquidity risk in those regions. So, the credit spread of the EMB would be smaller if their economies are looking good.

3. Carry-trade and Carry-trade Activities on Emerging Market

What is carry-trade? Carry-trade in simply is an arbitrage strategy of buying a high yield investment asset financed by short selling a low yield asset. Japanese Yen, for example, has long been regarded as a low yield currency and it has been the global investors’ favorite (especially the Hedge funds and global speculators) for a long time.

In practice, evidence shows in the past few years, global investors have made a lot of "yen carry trade" in which they borrow (short sell) the Japanese yen from the Japan market and invested in the EMB with higher yield. According to a recent research in the Tokyo inter-bank market from Merrill Lynch, non-Japanese banks’ funding has surged from Y 1500 bn to Y 7500 bn since the end of 2005. If the carry-trade activities from local Japanese bank and Japan household were counted, the amount of capital involved in carry-trade would be even greater.

As there is such a great amount of capital form "yen carry-trade" to emerging market, “the interest rate change of Bank of Japan (BoJ) will cause a worldwide market upheaval” said BusinessWeek, July, 2006. And it is expected that Japan interest rate become a more important factor in affecting emerging market credit spread.

Fig. A. (middle line) shows the credit spread of S. Korea with respect to Japan Yield

 The above is first part of a recent paper on fixed income securities completed by the writer,13/5/2007. Tomorrow, the writer will share with you the second part of the paper, which gives analysis and explanation on the current situation of credit spread.

Useful link

FX Deposit Rate Spread Among Banks in HK »È¦æ¥~¹ô¦s´Ú§Q²v¤§®t§O

  FX! Foreign exchange was the actually the first investment that the writer took! In 1992, when Spain was holding the Olympic games, Spainish currency provided a very high deposit rate. And it was the first time that the writer was asked by his mum to put all the pocket money in buying Spanish.

   It sounds risky, right? The writer really want to find out  how much he lost or gained at that time, but none of the transaction record can be found! (May be the writer's mum was afraid of being blamed when the writer grow up, and burnt all the transaction records that time) Nevertheless, the Spanish currency was disappeared in the world, and of course the writer would not blame his mum anyway! What's important here is that the saving deposit rate of different FX currencies is a key factor we need to take care of when we make FX trading.

Well, in Hong Kong, it is discovered that when we take FX trading at different banks, deposit rate may be very different. For example, in BOC(Hong Kong), its Euro current saving deposit rate is 0.5%.But at the same time, Wing Hang Bank provides the Euro current saving deposit rate as 1.75% which is 3.5 times of BOC one. Another example, for Japanese Yen, BOC(HK) provides a rate of 0.0001%, while Chong Hing Bank provides a rate of 0.005%(50 times that of BOC(HK)) and Wing Hang Bank provides a rate of 0.01%(100 times that of BOC(HK)). No matter which currency one is going to buy, a smart investor should take care of the deposit rate spread between different bank in HK.

The following is a comparison table that the writer made today. Readers can take it as reference.(The most updated deposit rate can be checked online.)

NZ Saving deposit rate	Current	7 days	1 month	1 year
BOC (Hong Kong)	3.1875	4.4600	5.6400	6.2600
Chong Hing Bank	5.0000	6.9375	7.0000	7.3750
Wing Hang Bank	5.2500	6.6200	6.9600	N/A
AUD Saving deposit rate
BOC (Hong Kong)	2.5000	3.7900	4.1000	4.8000
Chong Hing Bank	3.7500	5.6250	5.7500	6.0000
Wing Hang Bank	4.0000	5.2900	5.6800	N/A
EURO Saving deposit rate
BOC (Hong Kong)	0.5000	1.6600	2.0800	2.7200
Chong Hing Bank	1.5000	2.9375	3.0625	3.4375
Wing Hang Bank	1.7500	2.6800	3.0600	N/A
YEN Saving deposit rate
BOC (Hong Kong)	0.0001	0.0001	0.0001	0.0010
Chong Hing Bank	0.0050	0.0100	0.0100	0.0100
Wing Hang Bank	0.0100	0.0100	0.0100	N/A
CAD Saving deposit rate
BOC (Hong Kong)	2.0000	2.2800	2.4500	2.6700
Chong Hing Bank	2.1250	3.6875	3.7500	3.7500
Wing Hang Bank	2.7500	3.5700	3.7000	N/A

2007 Focus (Hong Kong II) 零七香港市場前瞻 II

As mentioned, the Hong Kong financial market would be expected to be fructuated in 2007. Here in second part, the writer will suggest some advice for the public investors in 2007.

I. Decrease the proportion of investment on equity, increase the investment percentage on fixed incomes.

As Hong Kong's market increased a lot last year, its potential risk of downturn also increases. If the public market do not want to take this risk, it is advised that they should take some profit of their current holdings and hold less stocks. In contrast, they can invest more in fixed income product like bonds,bills and notes. They provides more stable income for investors whenever the stock market is fructuated or not. Just kindly  reminded that fixed income product would be affected by interest rate, credit risk and exchange rate. Investors should also take a consideration of these factors before they make their decision.

II. Invest in mutual fund rather than choosing the stocks yourself

In this year, investors may find that it is more difficult to choose the suitable stocks themselves. It may be becuase of the very high P/E ratio of the stocks  or some of the stocks have recently reached their historial highest prices. Instead of spending a lot of time in figuring out the suitable stocks, they can invest in some mutual funds.Mutual fund house has a team of professional analysts and managers to investigate and trade in the market. Moreover, as most of them hold a basket of stocks at the same time, it certainly gives a diversification to your investment portfolio. But the same as fixed income products, mutual fund would also need to take risk. Investors is advised to take a deep look to search around the different fund house and their managemnt fees. What's more important is to choose the right market!

III. Using derivatives for hedging

Yesterday, the writer received a comment form reader KCmui. He raised a good question. The writer agree with him that the common use of warrants and call /put options by the general public in Hong Kong as investment vehicles may a bit like gambling bets. Well, what can be said is that warrant and option can raise risk level, but they can also balance the risk level in hedging. If the financial market is really going to be fructuated, using derivatives as a hedge tools for the current stock portfolio is definitely a good choice. However, the key point is that, derivatives are not easy tools! It is not advised that the public investors go to invest in warrant without fully understanding of its structure and its nature.

It is announced yesterday that the ICBC(1398.HK) and China Life Insurance(2628.HK) will become the blue trips with effective starting on monday 12th Feb,2007. It is expected that more H-share stocks will be regarded as blue trips in the future. In other words, the HSI would be more dependent on China enterprise. The investor should take care of this, and make suitable arrangement to their current holdings this year. At last, let the writer say a chinese new year greeting word to all of you,"Kon Hei Fai Choi"!

2007 Focus (Hong Kong I) 零七香港市場前瞻 I

Hello, Everybody! After having half-year canada exchange life, the writer is back!

There are few days left to the Chinese Lunar New Year. In the coming days, the writer would therefore like to talk about his view on financial markets of the coming New Year. Today, he is going to talk about the market of Hong Kong first.

  In year 2007, as what happened in January, the financial market (Hang Seng Index) will be quite fluctuated. In other words, you may say that it is difficult to be predicted when compared to last year. Last year, as can be seen, the HSI has been pushed up quite a lot due to the huge cash inflow from the frequent IPO of the China enterprises. However, this year in 2007, the reported IPO case is far less than that of 2006. What's worse, those big companies like the ICBC, BOC...etc have already gone through the IPO as H-shares in HK, the volume of IPO in 2007 is thus expected to be far lower. Without the good and clear news of IPO, the Hong Kong market will be very depend on the global trend and institutional investors' direction.

As shown by the following graph, the writer generally thinks that the HSI will rise up in the first quarter to a certain point (around 22000). In the second quarter, probably after the main companies have announced their 2006 performance, the HSI will fall down (to a point around 19000) because of the " Over-Reflected " of information and the high P/E of the some companies. The market then will possibly take a rest during the third quarter. In the last quarter, the HSI may have chance to rise up again due to the continually improvement of the performance of the different companies. And what's more, as the 2008 Beijing Olympic will come soon, the Olympic-related companies will attract the investors again.

So, in such a fluctuated year, what should we do? What is the safer way to invest this year?

The writer will share with you his suggested strategy tomorrow.