Flood Damage, Inflation to End Indonesian Bond Rally, DBS Says

Investors should sell Indonesian government bonds, Asia's best-performing last year, after floods ruined crops and damaged roads, causing inflation to accelerate, DBS Bank said.

Yields on the nation's 10-year debt may rise as high as 11 percent by year-end from the current 10.1 percent, said Lee Boon Keng, a strategist in Singapore at DBS, Southeast Asia's largest lender. Indonesian bonds have fallen for the past three weeks as the worst floods in Jakarta since 2002 pushed food prices higher and limited the central bank's room for interest-rate cuts.

``We're telling folks you're better off reducing your positions,'' Lee said. ``The policy rate cuts are coming to an end, and the inflation rate is rising.''

The floods, which forced nearly 600,000 people to flee their homes during its peak, have reversed progress by policy makers in cooling inflation in Southeast Asia's largest economy. The government on March 1 will report consumer prices for February, while Bank Indonesia on March 6 will decide whether to lower its benchmark rate for a 10th time since May last year.

Indonesian government bonds dropped 0.2 percent this month, the worst performance in Asia apart from China, according to indexes of 10 of the region's local-currency markets compiled by HSBC Holdings Plc. The securities handed investors a return of 29.5 percent last year as the economy recovered from the shock of a reduction of fuel-price subsidies.

The yield on the 10 percent note due in July 2017 has risen 15 basis points this month to 10.11 percent, according to the Inter Dealer Market Association. An increase to 11 percent by year-end would hand investors a loss of 5.2 percent on the face- value of their bond holdings, with coupon payments making total returns a positive 3.5 percent, according to Bloomberg data.

Floods in Jakarta

``There is a possibility that inflation will reach the upper level of our forecast'' of as much as 7 percent, central bank Governor Burhanuddin Abdullah told legislators yesterday. ``In February, inflation will be twice its normal level because of the floods.''

The central bank will probably wait until the second quarter to cut its benchmark interest rate, Deputy Governor Hartadi Sarwono said in an interview on Feb. 15. The central bank has lowered its reference rate for bill sales to 9.25 percent from 12.75 percent at the start of May.

``The market is pricing rates at 8 to 8.5 percent by the end of this year,'' Lee said. ``What BI is telling people is maybe 9 percent is where they will stop.'' DBS favors switching to bonds in Malaysia, where the central bank may allow the currency to appreciate to cool inflation.

Pause is Temporary

Some strategists remain bullish on Indonesian debt.

Any pause in Bank Indonesia's interest-rate cuts is temporary as food prices will stabilize as the effects of the Jakarta floods wear off, said Edward Lee, a senior strategist at Standard Chartered Bank Plc in Singapore.

Overseas investors have already started selling. They held 54.83 trillion rupiah ($6.05 billion) of Indonesian government bonds in January, down from 54.92 trillion rupiah in December. Holdings had risen five-fold from 10.7 trillion rupiah at the start of 2006.

APS Komaba Asset Management in Singapore, which manages about $330 million in fixed-income assets, sold Indonesian debt at the start of February, chief investment officer Lim Heong Chye said.

``The yields have come down a lot already and the rupiah has strengthened,'' Lim said Feb. 7. ``It was prudent to lighten our positions.'' The decision was prompted by reports of possible floods and the spread of bird flu, which has killed 63 people in the nation, Lim said.

`Not Just Rice'

Indonesia may report that consumer prices rose 6.7 percent in February from a year earlier, according to the median estimate of 20 economists surveyed by Bloomberg News. January's inflation was 6.3 percent.

``It's not just rice,'' said Lim Su Sian, an economist at DBS, who predicts inflation will average 7 percent this year. ``Other food items have increased in price because of poor harvests, transportation issues and problems with hoarding.''

Food prices may rise further as the January to April rice harvest will be ``significantly below average'' because dry weather delayed the start of last year's planting season, DBS's Lim said.

Indonesian bond yields have narrowed relative to those of developed countries' debt, reducing the scope for Bank Indonesia to cut rates, DBS said. There is a potential for a reversal in capital flows into Indonesia given the increase in foreign holdings of government bonds in the past two years and the change in the market outlook.

The extra yield that Indonesia's 15-year bonds offer compared with similar-maturity U.S. Treasuries narrowed to 5.76 percentage points yesterday from almost 7 percentage points six months ago, according to Bloomberg data.

``Given that the U.S. Fed is more likely to deliver rate cuts later rather than sooner, the central bank now has to be more watchful of overly compressing interest-rate differentials on Indonesian assets,'' DBS's Lim said.

source:www.bloomberg.com