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Opening markets through a bond fund: The Asian
Bond Fund II
Guonan Ma
Bank for International Settlements
Representative Office for Asia and the Pacific
APEC SeminarDeveloping Asian Bond Markets: from Investors‘ perspective
4-6 November 2005, Shanghai
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The issues at stake
I. What is Asian Bond Fund II (ABF2)?
II. Why was ABF2 launched?
III. How is ABF2 structured?
IV. What are the advantages of ABF2?
V. 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:
1. Reserve Bank of Australia
2. The People’s Bank of China
3. Hong Kong Monetary Authority
4. Bank Indonesia
5. Bank of Japan
6. The Bank of Korea
7. Bank Negara Malaysia
8. Reserve Bank of New Zealand
9. Bangko Sentral ng Pilipinas
10. Monetary Authority of Singapore
11. Bank of Thailand
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Two stages of ABF: ABF1 and ABF2
ABF1: launched in June 2003;
US$1 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 US$2 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 US$2 trillion
The aggregate outstanding domestic debt securities of the 8 EMEAP markets approach US$1.4 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 =>
1. The Asia Pacific Economic Cooperation (APEC)
2. The Association of South East Asian Nations Plus China, Japan and Korea (ASEAN+3)
3. 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 =>
• 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
Domestic debt securities outstanding in East Asia1 In billions of US dollars
0
200
400
600
800
1,000
1,200
1998 1999 2000 2001 2002 2003 2004
Total
Private
1 Includes the bond markets of the eight EMEAP members China, Hong Kong SAR, Indonesia, Korea, Malaysia, the Philippines, Singapore and Thailand.
Source: BIS. Graph 1
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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 => 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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Pan-Asian Bond IndexFund (PAIF)
Chinafund
HongKongfund
Indo-nesiafund
Koreafund
Malay-sia
fund
Philip-pinesfund
Singa-porefund
Thai-landfund
Eight single-market funds
Chinamarkets
HongKong
market
Jakartamarket
Seoulmarket
KualaLumpurmarket
Manilamarket
Singa-pore
market
Bang-kok
market
Local currencybond markets
USD 1 billion
USD 1 billion
EMEAP’s investment inABF21
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:
1. Bond market size (20%)
2. Turnover (20%)
3. Sovereign rating (20%)
4. Market openness (40%)
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Market weights for the PAIF
SG
HKOthers
KoreaChina
Others
Korea
Singapore(SG)
Hong Kong(HK)
China
Based on market capitalisation alone Based on four factors
Note: Others comprise the remaining four EMEAP markets of Indonesia, Malaysia, the Philippines and Thailand.
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
Investors
PAIF trustee Market-makers
Stock exchange
Liquidity
Primary market Secondary market
Subscriptionand redemption
Buying and selling
Arbitrage
Participating dealers
Buying and selling
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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 => 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 China’s 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)
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
21.06.05 21.07.05 21.08.05 21.09.05 21.10.05
HK Fund
PAIF
MY Fund
SG Fund
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$)
96
97
98
99
100
101
06.07.05 20.07.05 03.08.05 17.08.05 31.08.05 14.09.05 28.09.05 12.10.05
Source: State Street Global Asset Management.
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PAIF weighted average yield vs. yield on comparable US Treasury
3.5%
4.0%
4.5%
5.0%
07.07.05 21.07.05 04.08.05 18.08.05 01.09.05 15.09.05 29.09.05 13.10.05
Weighted Average Yield
Yield, Similar Duration 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.
