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Asia bonds to sparkle on fleeing euro

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European investors fleeing the collapse in yields at home will keep Asian bond markets bubbling this year, say analysts.

"The European Central Bank's (ECB) aggressive easing has raised the prospect for a greater positive impact given the dominance of European investors in many Asian bond markets," said Alliance Bernstein Economist Vincent Tsui in a note last week. Indonesia, Malaysia and Thailand, where European investors have a greater presence, "may be the main beneficiaries."

The ECB launched a massive bond buying program on January 23, sending yields on European bonds to historical lows. German government bonds up to the 6-year maturity are now trading below zero, and "other European bond yields have dropped dramatically," Guy Stear, global head of credit strategy at Societe Generale, said in a note last week.

"Finding bonds with yields above 2 percent is becoming increasingly challenging," Stear said.

In contrast, yields on the benchmark 5-year government bonds in Asia were quoted at higher, much higher, levels: Indonesia's is at 6.903 percent, Malaysia's at 3.639 percent, and Thailand at 2.26 percent.

Demand increase to continue

Europeans have been the biggest investors in Asia's bond markets for the past decade and the flow has been on a sustained upward trend. Between 2011 and 2013, flows from the European Union (EU) to Asia have jumped from around $85 billion to over $120 billion, according to the Morgan Stanley note.

The size of the U.S. dollar denominated bond market in Asia excluding Japan is on track to grow fivefold in 2 to 3 years' time to $1 trillion, from $181 billion in 2014, Morgan Stanley's head of Asia fixed income research and credit strategist Viktor Hjort said in a note published last week.

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Investors "may have been accelerating their buying in Asia, ahead of the anticipated launch of the quantitative easing program by the European Central Bank," Tsui added, suggesting the 2014 figures may show even greater flows from EU to Asia.

Furthermore, "the outlook for lower inflation and the prospect of Asian central bank easing in the upcoming months would also support local bonds performance and narrower sovereign spreads," Tsui added.

Morgan Stanley's Hjort agrees: Demand from Asia-based investors and pension funds has "been particularly strong."

Not so fast

Some investors are more cautious.

"We are optimistic about the outlook for Asian bonds, but not bullish because of the material risks that investors can't ignore," said Aberdeen Asset Management's Head of Fixed Income Asia-Pacific Victor Rodriguez.

One risk is the on-going uncertainty over the situation in Greece, which could spark yet more volatility in the European markets, he said. Another is the possibility of low commodity prices, particularly oil, causing defaults by companies in that sector.

Last but not least, expectations for a rate hike by the U.S. Federal Reserve could also increase volatility in the global markets.

Still, Asian bonds are more attractive in relative terms and present an opportunity to diversify out of euro zone credit, he said.