IDR Rates: Time to catch up
- Indo GB are lagging peers in the market recovery
- There is room for Indo GB to play catch up in 2H
- A return of foreign interest would be key
- This could be facilitated by a return of the carry environment
Indonesia Rates: Catchup play
The rally in Indonesia government bonds have further to go and we think that the belly tenors may be the best way to express this view.
Within Asia, Indo govvies were one of the worst hit when foreign portfolio investors exited. From a govvie perspective, 10Y Indo yields touched as high as 8.38% in late March (from as low as 6.5% in mid-February) when global markets got roiled. While yields have retraced a sizable amount (10Y yields are now hovering around 7.2%), Indonesia government bonds have lagged that of peers in the region. Accordingly, we see Indo govvies as a catchup play over the medium term with foreign investors
likely to revisit the carry theme.
The underperformance of IndoGB can be attributed to a few factors. First and most importantly, foreign investors are still somewhat cautious. Foreign investors now own 30% of outstanding government bonds, down from almost 40% in late January. While caution on this front is warranted given uncertainties over the evolving COVID-19 situation, we think that investors will eventually be persuaded to return. Across much of the developed world, rates are likely to stay relatively depressed. If the Fed eventually embarks on yield curve control (YCC), reduced uncertainties on this front should also encourage carry trades. Moreover, hedging costs (as represented by NDFs) have collapsed close to pre-COVID-19 levels.
Second, Bank Indonesia prioritises the currency and sees the rupiah as undervalued. This point can be best seen from the performance of the IDR and the pace of accumulation of foreign reserves over the past two months. While foreign reserves did rebound in April and May, current levels are still slightly below that of end-January (USD131.7bn). Comparatively, India’s foreign reserves are up by close to 8% over the same period. Due to BI tolerating a faster pace of rebound in the rupiah, domestic IDR liquidity conditions are not quite as flush as it could have been.
Domestic agents key for bond demand
BI is already buying government bonds, with much of the purchases concentrated at the during stressed financial market conditions in 1Q. BI’s gross ownership rose to 14.4% of total outstanding IndoGBs, up from 9.9% at the start of the year. More recent development that BI will finance part of the government’s debt (IDR397tn) at a benchmark rate (with interest set to be returned to the government) and co-fund another IDR176.8tn of debt may be somewhat uncomfortable for investors. However, the key focus should be on the fact that LCY govvie issuances are likely to be lower than it otherwise would have been. We also consider that Indonesia is diversifying its investor base and has issued Samurai bonds (JPY100bn) in in early July tapping on global investors’ appetite for yield (but with less fx risks).
Our Asia Rates Valuation Indicator (ARVI) suggests that Indonesia government bonds are still cheap. While yields have declined a significant amount, there is room for further gains once sentiment improves. At this point, there are still concerns on the COVID-19 situation in the country. More broadly, appetite for EM assets have not fully recovered. We think that interest in EM bonds would improve if the Fed strengthens forward guidance or embark on yield curve control (YCC). One way to view this is the period in 2012 where the Fed first introduced the dot plot and strengthened dovish forward guidance. By removing tail risks from USD rates rising suddenly, investors were emboldened to hunt yield. Conditions were also very favourable (hedging costs as measured by NDF points were generally depressed). We reckon that events could play out similarly as the world settle into a world of generally low DM interest rates, driving a second leg of rally in Indo govvies. We have revised down our Indo yield forecasts (see table below).
Assessment of Carry Attractiveness
From the perspective of Indo govvies as a pure carry opportunity, the timing appears to be favorable. Reward-risks measures of carry, such as ratio of spot yield to yield volatility, are elevated relative to historical. I.e. investors are well compensated for possible fluctuations in yields, at current volatility levels. On the currency front, continued stability in IDR, whether due to BI support or cheap hedging costs, should also underpin Indo govvies’ carry performance ahead.
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