TAILIEUCHUNG - Diversifying with Asian local currency bonds

A special feature in the BIS Quarterly Review of June 2004 profiled the Asian local currency bond markets as a potential asset class, contrasting their considerable capitalisation with their mixed liquidity. The article found that larger markets with larger issues saw more trading at narrower bid-ask spreads. For a market of a given size, concentration of holdings among investors depresses liquidity. A broader investor base might thus be expected to improve liquidity, particularly at times of stress (Jiang and McCauley (2004)). Foreign investors might find these markets’ recent performance attractive. Half of them returned more than US Treasury securities of similar duration on an unhedged basis from January 2001. | Robert McCauley 852 2878 7106 Guorong Jiang 852 2872 2062 jianggr@ Diversifying with Asian local currency bonds1 Asian local currency bonds offer diversification potential in global bond portfolios. JEL classification E440 G150 H630 O160. A special feature in the BIS Quarterly Review of June 2004 profiled the Asian local currency bond markets as a potential asset class contrasting their considerable capitalisation with their mixed liquidity. The article found that larger markets with larger issues saw more trading at narrower bid-ask spreads. For a market of a given size concentration of holdings among investors depresses liquidity. A broader investor base might thus be expected to improve liquidity particularly at times of stress Jiang and McCauley 2004 . Foreign investors might find these markets recent performance attractive. Half of them returned more than US Treasury securities of similar duration on an unhedged basis from January 2001 to March 2004. This special feature addresses the question of how such bonds might fit into a global bond portfolio. Asian local currency government bonds offer scope for diversification since their returns co-move only moderately with their US Treasury counterparts. In particular their correlations with US Treasury bonds mostly lie below those of euro area or Australian government bonds. If Asian bonds risk is measured by just the volatility of returns then only by being combined in a portfolio would they offer a favourable risk-return trade-off relative to US Treasury bonds. If risk is measured by co-movement with the US bond market almost every Asian bond market shows a very favourable risk-return trade-off. The scope for diversification is greater for bonds of lower credit standing and for less globalised domestic bond markets. In particular non-investment grade local currency bonds show lower correlations. These also tend to be lower in markets with a more limited presence of international

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