Analyst cautions against Indonesia’s 10-year government bonds

Even more interesting to note is the fact that the BI rate was at 6.50% last year, compared to the current 6.75%, which means that the rate differential between the BI rate and the 10-year yields is even lower now than last year. Going forward, we find it hard to justify calling for further downside in the yield for 10-year bonds even if it now seems that we are still some distance away from seeing the BI delivering any rate hike.

Hardly surprising, investors have continued to favour Indonesia and it is not hard to find reasons why. The latest ADB outlook is just another positive for Indonesia, as it was singled out as the only economy that will buck the trend of moderating economic growth in Asia going into 2012. Net foreign flows into the local government bond market have scaled new highs, and total foreign ownership in
outstanding bonds is currently just above 35%.

Interestingly, despite several local names appearing to have turned more cautious in the bond market in recent months, most players have continued to go with the flow in the market, taking the lead from foreign names. Appetite remains fairly strong across the curve, especially noting the strengthening prospect that underpins the IDR. The notion that Indonesia is currently in a ‘sweet spot’ has certainly continued to buoy sentiment in the market, and this is also evidenced in the strong performance in the JCI in the year-to-date.

The inflation story has also continued to support sentiment in the local bond market. With inflation easing to 4.6% yoy in July, even a typical 1% mom inflation that is usually seen during the Ramadan month (August for this year) may only bring headline inflation to about 6.3% yoy in September, still within the BI’s comfort range.

As it is, we now expect headline inflation to average close to 6% yoy for the year, well above our already revised 6.7% forecast previously. A combination of factors is
clearly at play here, but none more important than the abundant food supply that has led to falling food prices since the start of the year (although anecdotal evidence shows seasonal increase in meat prices in recent weeks).

Yet, we continue to see plenty of risks to domestic inflation; with the biggest being the possible fuel subsidy reform that may still happen this year despite the government having recently denied planning to do so. As it is, in line with the longer-term fiscal consolidation measures still in place, the implementation of fuel subsidy reforms is only a question of the timing. Accordingly, going further out in H2, we should see clearer signals from the BI with regards to its mediumterm rate trajectory.

Most in the market still expect the central bank to deliver one 25bps rate hike by the year-end (we were in the increasingly small group that expected a total 50bps in rate hikes) with eyes on core inflation, which has remained relatively high at 4.6% yoy in July. Noting a recent comment by a BI official on a possibly slower pace of IDR strengthening forward, we expect a shift towards more domestic monetary tightening in the medium-term.

Against this backdrop, we expect long-term inflation trend to return towards 7-8%, higher than the current yield seen for 10-year IDR bonds. As such, we find it really hard to justify calling for further downside in the yield for 10-year bonds, which have been a popular investment target in 2011. While the probability of a higher BI rate continues to fall and should be a positive for the overall bond market, there is a need to be even more selective at this juncture, given how deep the rally in the bond market has been.