Outlook for the Asian Credit Market in 2004

We expect the positive macroeconomic background in Asia to persist in 2004. Our base case is for growth to pick-up in G3 economies (US, Euroland and Japan), leading to a coordinated global recovery. Asia will benefit from a pick-up in exports to these markets. Additionally, growing domestic demand and stronger inter-regional trade, driven by China, will add further impetus to growth. Thus we still expect the environment to be credit friendly in 2004.

The positive macro environment will enable corporates to continue strengthening their financial profiles. Sovereigns too will benefit from stronger growth, which should lead to improving fiscal profiles. Thus, we would expect the positive rating trend seen in the past three years (see chart) to continue in to 2004.

Another positive aspect of the Asian credit market is the healthy and growing supply. Gross issuance of Asian eurobonds was a record US$30 billion in 2003, up from US$20 billion in 2002. It is expected that 2004 supply will marginally exceed that of 2003.

The healthy levels of new issuance help ensure that breadth is maintained in the market and that market prices are reflective of credit fundamentals. Among the new supply expected are first time issuers, which generally offer diversification benefits and greater relative value. Given the amount of liquidity in the system, we believe the new supply should be met with adequate demand.

Another major consideration when assessing the outlook for Asian credits in 2004 is the political calendar. As detailed in the following table, eight Asian countries will be holding elections. While we expect most elections to be held peacefully and result in minimal economic policy changes, it is always the unexpected which haunts the market. Elections always contain room for surprises, which could add to volatility in Asian credit markets.

Finally, investors in Asian credits will likely have to deal with rising US Treasury yields. Hence duration management will become an increasingly important consideration.

Performance of Asian Credit Hedge Fund

The Asian Credit Hedge Fund (ACHF), which was launched in February 2002, has performed well since inception. The fund returned 14.1% in the Feb-Dec 2002 period, and 12.5% in 2003.

The following table compares the fund's returns to returns of JP Morgan's Asian Credit Index (JACI) and Merrill Lynch's US Treasury Index.

As can be seen, the ACHF has performed well in different credit and interest rate environments. Another point to note is ACHF's lower volatility. In the combined 23 months, ACHF's standard deviation (0.6%) was significantly lower than that of the JACI and the ML UST index. Similarly ACHF demonstrated a lower number of down months and a higher Sharpe Ratio - indicating better risk-adjusted returns.

ACHF's Strategy for 2004

In our opinion, ACHF's multiple-strategies and hedging techniques are well suited for the above-described environment, where we are likely to witness rising yields, potentially increased volatility and more selective spread compression. The following strategies are expected to enable us to achieve double-digit returns in 2004 with limited monthly volatility.

A. Core Credit Selection

The core of ACHF's strategy is to long / trade a core portfolio of credits, which are expected to demonstrate improving credit fundamentals and/or offer significant relative value opportunities.

This will include a diversified portfolio of bonds, loans, perpetuals and convertible securities. In addition, the portfolio will normally include 15-20% in special situation investments, which are usually characterised by deep discounts and exceptionally high return potential. The fund is not constrained by currency, rating, structure or tenor of any investment, as unwanted risks can be hedged away.

The ability to invest in multiple asset classes improves the fund's investment options, enables us to seek the best value, and helps generate returns in different market environments. For example, yield curves of different currencies do not necessarily move in tandem. Similarly returns of special situation investments, convertible bond and high-grade bonds are not necessarily correlated.

Given our positive macro views, we expect higher-yield and special situation investments to outperform this year. Hence these areas will be the focus of our credit portfolios, especially given that they are less correlated to US Treasury movements. We also expect convertibles will benefit from stronger equity markets. Rather than taking outright equity risk we will focus on balanced convertibles offering yield with some equity upside.

The core credit portfolio, described above, is augmented by the following strategies aimed at enhancing returns and reducing volatility.

B. Interest Rate Hedging

ACHF dynamically manages its interest rate exposure through the use of US Treasury futures, options and swaps. This enables us to protect the portfolio's returns against adverse movements in government bond yields.

The fund has a successful track record of managing interest rate volatility. For example, in 2003, Merrill Lynch's US Treasury Index recorded a negative return in five months out of 12 months. By contrast, the fund was able to generate positive returns in four out of these five months. The only exception was July 2003, when the Treasury index dropped 4.24%, and ACHF fell by 0.70%.

C. Credit and Macro-risk Hedging

ACHF also uses credit default swaps to manage overall country exposures and macro risks. For example, we may have favourable credit opinions on certain corporate credits in the Philippines, but we may be cautious on the country's macro-economic and/or political situation. In this case we may long the corporate credit and short the sovereign component by buying CDS protection on the sovereign. Similar strategies are also used to manage overall net country exposure on a portfolio basis.

The fund also invests in various currency, commodity and equity options as long-term sleeping hedges against potential market surprises. These hedges are unlikely to ever come in-to-the money. However, we believe they offer the portfolio protection in the event of unexpected situations. We limit the annual cost these hedges to just about 1% to 1.5% of the fund's NAV.

ACHF's Country Outlook

+: Favourable conditions for spread tightening
-: Unfavourable conditions for spread tightening