Morgan Stanley sees once-in-a-decade opportunity for credit

What will be the key macro trends for Asian fixed income this year?
The past two years were the most volatile on record. For example, if you bought a portfolio of corporate bonds at the end of World War II, by the end of 2008 you would've lost your entire cumulated excess returns, only to recoup them again in 2009. That volatility won't return and it's mathematically impossible to beat the kind of returns we had in 2009.

Going forward it is best to focus on the most interesting parts of the markets. We view financial institutions, the high-yield markets and the lessons learnt from Dubai last year, as the main points of interest for 2010. Out of these, the macro trends are favouring banks.

Credit markets are peculiar because in every downturn there is one part of the market that does exceptionally worse than everything else; causing the downturn. In the early 1990s the problem sector was banking; in 2002/2003 it was technology, media and telecommunications; and this time again it has been the banks.

The problem sector will emerge from recession the cheapest and chances are will do a complete turnaround coming out of a downturn. That's what happened to banks in the early 1990s and TMT in 2003 and that's what is expected for banking this time round.

Almost all the initiatives coming from regulators (US, Asia or Basel III) are generally negative for growth in the banking sector, yet positive for bond holders. They create less risk, less risk-taking and higher capitalised institutions with stickier funding. They also create more boring, yet safer asset portfolios. This is a credit-friendly trend and one thing we're certainly telling investors to focus on.

What structure can we expect banks to use for their bond issues?
This will be a really strange year for financials because they will be raising capital in one part of the market and they will be redeeming capital in others. So it can be tricky to know what's going on.

The best way to make sense of this is by coming back to this regulatory trend. We had a downturn where banks went into the recession with fairly elaborate capital structures that ranged from senior debt at the top to subordinated hybrid debt below, and then common equity at the bottom. The recession proved that the bank capital mechanisms didn't work -- junior hybrid debt didn't absorb the losses that they were supposed to and banks became extremely reluctant to issue tier-2 debt.

These lines of defence that were built up over the years by regulators and banks folded under the pressure. As a result, the global regulatory environment became disillusioned with the loss-absorbing performance of sovereign capital. Regulators are now telling banks to get rid of the structure and no longer rely on hybrid tier-1 or tier-2 debt. The message is to build up reliance on core tier-1 and senior funding.

The middle part of the capital structure will shrink with more reliance on the top (senior debt) and the bottom (equity). When you see where the issuance is coming from banks globally, it is equity. There were a lot of financials raising equity last year, which has continued into 2010.

Asian economies are underleveraged compared to more mature economies. As a function of economic growth, we will see a gradual maturing of household use of leverage. Banks are growing their balance sheets faster and that's going to require capital. Banks will look to increase senior and lower tier-2 debt capacity and equity.

Going forward, banks need funding either through raising equity or raising senior debt. There is significant uncertainty over the future landscape of the capital structure and investors, issuers and arrangers alike won't know [what it will look like] until the Basel III documentation has been received at the end of this year.

What is the impact on the region from the liquidity tightening in China?
This is an unusual cycle because for the first time Asian central banks are leading the tightening coming out of the downturn and equity markets clearly don't like it. Historically, this is a situation that has led to near-term volatility. [But] as markets get used to the idea that it's tightening for a good reason, it won't change the underlying trends in either asset markets or volatility. The credit spreads will continue to decline and equity volatility will continue to decline as well. It fits very well with historical patterns, where spikes in volatility accompany no change in trend.

What it also does is put the spotlight on the parts of the markets that are most sensitive to policy tightening. Given the unusual amount of credit expansion in China in the past 12 months it draws attention to the bond market side.