Manila, Philippines (BBN)– Emerging East Asia’s local currency bonds are still in demand from domestic and offshore investors, but the region’s markets face increasing challenges, the Asian Development Bank (ADB) said on Tuesday.

Emerging East Asia’s local currency markets continue to expand, but at a slower rate than previously. At the end of September, the region had $5.5 trillion in outstanding bonds, 5.5 percent more than a year earlier in local currency terms.  That compared with a year-on-year growth rate of 7.6 percent at the end of the second quarter of 2011.

The expansion in the third quarter was largely due to strong growth in the region’s corporate bond market, which expanded by 15.4 percent, while the government bond market grew by a smaller 1.3 percent, according to the latest Asia Bond Monitor released on the day.

“Still, risks to the outlook include growing uncertainty surrounding the European economies, which is generating volatility in global and regional markets and a flight to safe-haven investments. Furthermore, the slowdown in Asia’s economic growth and the potential for abrupt capital outflows are also challenges,” it added.

The report assesses the bond markets of the People’s Republic of China (PRC); Hong Kong, China; Indonesia; the Republic of Korea; Malaysia; the Philippines; Singapore; Thailand; and Viet Nam.

Bonds issued by local governments could become an interesting new asset class in the local markets.  The Thai government now permits issuance by local governments and the companies they own. Meanwhile, the PRC recently approved  issuance of bonds by the  municipal government of Shanghai and the province of Guangdong for CNY7.1 billion and CNY6.9 billion, respectively.

Yield curves in most markets have flattened and in some cases shifted downwards as markets and policymakers focus on supporting growth rather than stemming inflation. Declining yields, particularly for longer-dated bonds, offer governments in the region an opportunity to raise cost-effective debt should they need to finance additional borrowing.

Viet Nam was the fastest-growing local currency bond market in the third quarter, expanding 22.2 percent on year to $17 billion. The corporate bond market grew by a strong 34.7 percent with the government bond market increasing 21.1 percent.

The PRC has the largest local currency bond market in emerging East Asia with $3.2 trillion in bonds outstanding at the end of September. That was 3.5 percent more than a year earlier and 0.5 percent more than at the end of June.

The 20.0 percent year-on-year growth in the corporate bond market contrasted with the 0.7 percent contraction in the government bond market, the Monitor added.

Bond issuance in the region totaled $829 billion in the third quarter, up 7.6 percent versus the second quarter but down 19.9 percent year-on-year as central banks reduced sales to offset foreign exchange inflows. Corporate issuance was also down 24.4 percent on a year-on-year basis. This decline, however, was from extraordinarily high levels in 2010.

As of the end of October, borrowers in emerging East Asia had raised $63 billion in so-called G3 bonds – or bonds denominated in US dollars, euros or yen — suggesting the region may, after all, fall short of the record $87 billion in issuance witnessed in 2010.

BBN/SSR/AD-29Nov11-8:16 am (BST)