While part of the outflows was likely index-driven and due to outflows from broader EM (IndoGBs hold large weights in key EM LC bond indices), foreign investors have also been bearish on IndoGBs as seen by their positioning. Based on our tracking, managers of major EM LC bond funds have held underweight on IndoGB duration throughout this year. They were initially overweight IDR FX in 1H but subsequently turned underweight too in 3Q.

The rationale for investor caution

IndoGB total returns have actually been resilient year-to-date, outperforming US Treasuries. So why have foreign investors been cautious and stayed away? There are two main reasons. One, Bank Indonesia (BI) was relatively late in starting its rate hike cycle. As a result, offshore investors initially worried BI could be behind the curve. After BI started hiking 50bps at the September and October meetings, offshore concerns shifted towards uncertainty around the terminal policy rate and its implications for IndoGB yield levels. Hence, some investors have preferred to stay on the sidelines until they get more clarity on the length and size of BI's hike cycle.

A second reason for foreign investors being cautious has been valuation-related concerns. Specifically, the nominal yield differentials that IndoGBs offer over equivalent-maturity US Treasuries are at the tightest levels in many years. 10Y yield differential is currently at 320bps vs historical range of 400-600bps. Some investors therefore point to the tight yield differentials as the basis for the view that IndoGB duration has little room to rally but large room to sell off.

Our IndoGB outlook

We understand the rationale for investor concerns around the BI hike cycle and IndoGB valuations. But these are not sufficiently strong reasons to be overly bearish on the forward return potential of IndoGBs. In fact, we have recently turned bullish on IndoGBs and see IndoGBs as one of the EM bonds that could durably outperform in the coming 3-6 months. We think there would be a turnaround in foreign bond flows and expect inflows of USD3-7bn in 2023.

For most EM ex-China bonds, the outlook for US rates and broad USD matters greatly. With the US Fed expected to downshift to smaller hikes and be more data-dependent, and Fed pricing already near our peak Fed Funds forecast of 5%, that gives us some comfort that short US rates and the associated external pressures on Asia LC bonds could be approaching a peak. Global growth risks could, however, become more apparent in 2023 due to this year's policy tightening. Macro uncertainty is thus expected to stay elevated, and we favor IndoGBs for their relatively higher yields and stronger fundamentals.

BI has turned more pre-emptive and front-loaded against inflation and currency risks, and Indonesia's fiscal consolidation is faster than regional peers. This should assure foreign bond investors that policymakers are credible in terms of their normalization efforts and are not behind the curve.

For the next couple of quarters, we expect Indonesia's balance of payment (BOP) dynamics to remain supportive for IndoGB total returns. Trade and current account balances continue to be uplifted by commodities terms of trade shock, particularly from elevated coal export prices. FDI prospects and foreign equity inflows are also expected to stay healthy. While foreign bond outflows have been persistent, we expect outflows to turn around soon.

Domestic liquidity and local bond demand is one aspect that favors IndoGBs over several other Asia government bond markets. Even though excess liquidity has declined materially this year on BI's RRR hikes and pick-up in credit growth, levels of excess liquidity are still considered comfortable. They support local bond demand (banks, retail, insurance/pension funds). BI would be accelerating private placement purchases under the burden-sharing in 4Q, allowing issuances to be light through year-end. The expected end to burden-sharing arrangement in 2023 could bring bond supply-demand gap risks. Still, we think excess liquidity, carry-forward of surplus government cash balances and expected turnaround in foreign bond flows would be sufficient mitigating factors.

Addressing valuation concerns

We look at three valuation measures to address valuation concerns that might be holding foreign investors back from being more bullish on IndoGB. IndoGB valuations are certainly not cheap, but they also do not appear to be overly expensive (in a stretched way). There is scope for 10Y IndoGB yields to fall without creating excessive valuation pressures.

(1) 10Y IndoGB-UST nominal yield differential

Historically, nominal yield differentials have been contained in a +400 to +600bps range, acting as a proxy for a domestic and global risk premium. During times of crisis or extreme risk aversion, differentials could overshoot above 600bps, such as during the CNY devaluation in 2015 and the onset of the pandemic in 2020. When the global outlook is strong, differentials could undershoot below 400bps, such as during global synchronized growth in 2017. In today's context of restrictive Fed and ongoing global stagflation risks, some investors feel that IndoGBs should sell off such that yield differentials widen to more than 500bps, to provide sufficient risk premium against Fed and global risks.

We push back on that view. There have been structural improvements in Indonesia's current account profile post-pandemic, resulting in a lower reliance and sensitivity to foreign bond inflows. With a much lower ownership share of foreign investors, there is a weaker justification for IndoGBs to maintain yield differentials that would be considered historically attractive (to draw foreign bond inflows). Post-pandemic, bond buying from local banks and non-bank investors has also been robust, arguing for the greater significance of local factors (and lower significance of global drivers) in determining IndoGB yield levels.

Nominal yield differentials in 2023 can comfortably stay in a +300 to +350bps range, barring major crisis/stress events. At the current differential of around 320bps, it does, however, suggest limited room for further tightening of differentials. Based on our 2023 10Y UST yield forecast range of 3.60-3.90%, assuming stable yield differentials, we think 10Y IndoGB yields can trade to as low as 6.85%. 

(2) 10Y IndoGB real yields vs Current Account balance

Comparing 10Y IndoGB real yields (based on Core CPI) against Indonesia’s current account balances can be used to assess if the level of IndoGB yields is sufficiently high to compensate for Indonesia's internal (inflation) and external (current account) risks. Regressing over the 2010 to 2022 period and applying the model out-of-sample to our economist’s 2023 CA forecast of -0.5% (of GDP), we find that it produces a 10Y real yield at 4.00%. Thereafter, tagging on a projected 3.0% Core CPI for 2023 (BI expects Core CPI to return to the 2-4% range in 1Q), that results in a projected 10Y nominal yield of 7.00%.

(3) Spread between 10Y IndoGB yield and BI policy rate

Spread acts as a proxy to assess whether there is a sufficient buffer in 10Y IndoGB yields to account for BI rate hikes and the term premium. For this cycle, our economist forecasts another 75bps hike in 4Q and expects BI to stay on hold at 5.50% in 2023. That will bring the spread to around +155bps from the current +230bps if we hold 10Y yields at current levels. If we look at the last BI hike cycle from mid-2018 to mid-2019, the spread compressed to as low as +135bps after policy rates peaked. This suggests scope for further spread compression to drive 10Y IndoGB yields lower towards 6.85%.

Combining all three valuation measures, we think 10Y IndoGB yields trade in a 6.85-7.00% range in 2023. Our lower bound of 6.85% is supported by the first valuation measure (based on stable nominal yield differentials and 3.60-3.90% 10Y UST yields in 2023) and third measure (based on 5.50% BI terminal policy rate and compression potential for policy-bond spread). Our upper bound of 7.00% is supported by the second measure (based on 4.00% 10Y real yields and -0.5% (of GDP) CA). At the 10Y IndoGB yield of 7.03%, this implies 10Y IndoGB yields can fall 5 to 20bps from here.

Total return considerations

On the currency front, our FX strategist is forecasting USDIDR at 14930 at end-2Q23 and 14560 at end-4Q23. Based on the current level of USDIDR of around 15600, there is potential for currency translation gains of 4-7%.

Some bond investors point to IDR's underperformance vs other Asia FX in October as a cause for concern. Our take is that the extent of IDR's outperformance from January to September had been quite large, and thus, markets were always going to expect some convergence and some giveback was therefore due. In fact, during USDIDR's climb in September/October, we note that BI did not offer DNDFs at large discounts to encourage pick-up and offset hedging demand (unlike in June/July), which likely suggest that they were comfortable with the catch down in IDR towards other Asia FX. We think the recent pullback in IDR relative to other Asia FX removes the aforementioned convergence risk and provides a better entry point for being bullish IndoGBs.

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