The news that China has been buying South Korean treasury debt as a way of diversifying its foreign reserves will come as music to the ears of the Asian Development Bank (ADB). The bank has been in the forefront of efforts to persuade Asian governments to invest more of their vast surpluses in Asian assets rather than accumulate ever more bonds US and EU bonds. The Asian Bond Fund which is traded in Hong Kong jumped nearly 1 percent on this news.

Having become nervous about both the US dollar and the euro and already holding a lot, relative to market size, of Canadian and Australian debt, China has been buying a huge amount of yen debt, helping push the Japanese currency close to its all-time high. China's move into Japanese debt was actually rather belated, perhaps the result more of political antipathy than investment judgment.

But China's purchase of Korean bonds highlights both its wider search for diversity. It also points to major contribution China's surpluses could play in spurring Asian infrastructure investment if it means that countries such as Indonesia and Thailand are able to issue and sell overseas more public debt in their own currency and so eliminating the exchange rate risks incurred by borrowing with dollar and euro-denominated bonds.

Of course, Asian government bond markets other than that of Japan are tiny relative to the hundreds of billions of dollars still accumulating in the foreign exchange reserves of China and other Asian countries. But the moves are a reminder of how sluggish the private sector has been in encouraging Asians to invest in the bonds of their neighbors. Newspapers regularly publish prices and yields of sovereign bonds of Asian countries denominated in US dollars but seldom those in local currencies.

But in fact the local ones mostly now have higher yields than dollar or euro ones and many such as those of Singapore and Thailand have delivered significant exchange rates gains compared with the western currencies. Their main drawback is not so much solvency risk as withholding tax on interest paid to non-residents levied by some governments. China's move into Korean bonds could well be followed up with buying of the better quality southeast Asian sovereign debt.

The ADB has been promoting cross-border debt transactions for a number of years, particularly via its Office of Regional Economic Integration. Not only has the ADB itself issued increasing amounts of bonds in local currencies but through its website Asian Bonds Online has provided investors with an easy way to follow actual and relative performance in east Asian bond markets

Among the ADB's initiatives was the Asian Bond Fund – Pan Asia Index Fund which is both a bond index and an actual fund invested in local currency sovereign bonds and traded in US dollars on the Hong Kong stock exchange (2821.HK).

ABF-PAIF's current weightings are as follows:

China 20.5%

Hong Kong 19.27%

Korea 14.18%

Singapore 14.78%

Malaysia 10.59%

Thailand 9.50%

Philippines 5.49%

Indonesia 5.36%

For a long time after its launch in 2005, the ABF-PAIF was largely ignored by the market and often traded at a discount to its net asset value. However interest in it has been gathering pace due to its unique characteristics. The fund has been gradually expanded and now has over US$2 billion in assets and the units trade very close to their NAV. Indeed they have recently been trading at a 1% premium, an indication of their attraction as a way of locking into broader Asian currency appreciation while receiving a yield now at around 3.4%. Given that the bond portfolio's average maturity is five years, the yield is thus attractive compared with the roughly 2% of US and German five-year treasuries.

That said, $2 billion fund is still not very big in the context of global bond markets and indicates just how slow the average fund manager has been to recognize the potential of vehicles such as these. Fund managers at UBS in London told one client that they had never heard of it and advised against such a "high risk" investment.

Although the sovereign bond fund concept was originally aimed primarily at institutional investors it provides individuals with access to these foreign bonds markets and currencies which otherwise would be unavailable either due to large minimum investment requirements, outright bans on foreign ownership. The bonds also benefit from being exempt from the withholding tax applied by many governments to interest payments to non-residents. Trading is exempt from Hong Kong's stamp duty.

The fund's appreciation over the past year has been mainly due to the Singapore, Korean and Malaysian currencies. Future appreciation possibilities clearly depend heavily on what happens to the China and Hong Kong currencies – a big imponderable. But given the levels of liquidity in east Asia, local currency sovereign bonds seem sure to attract more Asian money and the five-year average maturity limits – though certainly does not eliminate – the danger of rapid rises in interest rates.