Asian high yield credits returned 6.2% year to date as measured by the JACI – Non-Investment Grade Index1. Performance has been driven by carry and lower US treasury yields. After spreads widened sharply in January on China concerns, they have compressed from March onwards due to improving sentiment towards China and a recovery in oil prices. Asian high yield credit spreads are now 39 basis points (bps) tighter (as at 31 May) than at the start of the year, which has also contributed to the performance of the asset class. By country, Indonesian high yield has been the key driver of the strong performance while selective China high yield names have also continued to perform well.
Our Investment Approach
Amid a very low global interest rate environment, we believe Asian high yield bonds will remain supported by better yield pick-up and favourable technical conditions. While fundamentals have weakened somewhat, default rates are expected to remain low and technicals continue to provide strong support.
An active approach to both bottom-up and top-down analysis is key to our success in this asset class. Our approach stresses rigorous bottom-up fundamental credit analysis for stock selection and credit differentiation to avoid idiosyncratic risks in Asian high yield. Our portfolio construction approach is dynamic: we are very cognizant of minimizing the impact of portfolio drawdowns when markets are more volatile. Given this, the portfolio managers focus not only on security selection opportunities (working closely with the credit analysts) but also managing overall portfolio risks, including interest rate risk and risks arising from macro-driven volatilities.
Our Asian high yield strategy has actively used US Treasury Futures and credit default swaps to reduce risks in the portfolio. In addition, we have also rotated into investment grade credits ahead of expected volatile periods. While we aim to minimize risk in more volatile periods, we also actively monitor for attractive opportunities when markets are selling off. Our strategy has benefited from taking positions in selective names that had sold off by more than valuations would entail and we have taken profits in some of these in recent months.
Asian credit fundamentals have been on a weakening trend, driven by slowing Asian economic growth along with weak external demand, which has led to falling earnings and rising leverage. However, we have seen some catalysts support improvements in corporate fundamentals. These include: easing in ratings pressures, improved liquidity positions, reduced concerns about China growth, currency and policy, easier global monetary policies, resumption of an onshore bid for China credit, and increased allocations to Asia credit from insurers in the region (e.g., Taiwan, Japan).
Moody’s ratings for Asian High Yield corporates have deteriorated only slightly in Q1 2016 as illustrated in the chart below and we expect the outlook should remain overall stable.
Asian Default Rate Forecast – still low
Overall, Asian high yield defaults remain at relatively low levels historically as illustrated in the chart below.
The Asian high yield corporate default forecast is generally in line with that of the global speculative grade default rate, which is in turn forecast to rise to 4.6% in 2016 from the current 3.8%, reflecting deteriorating credit conditions in the commodities sector, such as in oil & gas and metals & mining.
The default risks of Chinese property developers are relatively low when compared to companies in the metals & mining sector. In China, strong housing sales momentum was reported in the first four months of 2016, due to supportive monetary and regulatory policies. Residential home prices for China's 70 major cities continued their gradual recovery for the first four months of 2016. As we can see from the chart below, we draw comfort that the Asian credit market has a very low exposure to metals and mining at 3.1% whilst the oil and gas sector is dominated by state-owned entities, where we expect the default risks to be very low. In addition, we expect the earnings recovery trend of Indonesian corporates for the rest of the year and 2017 to improve given our expectations that the Indonesian economy will gradually recover.
Technicals – remains supportive
Strong technicals should also continue to support the markets in the near term. Asian high yield maturities for this year remain at manageable levels. Supply is tracking at around 26% lower than last year (as at 4 May 2016) due to cheaper onshore funding alternatives, overall lower capital expenditure due to slower earnings before interest, taxes, depreciation, and amortization (EBITDA) growth and volatility in the RMB. We expect these trends to continue, which should keep supply capped on the upside for this year. Demand remains supported by a growing local investor base (Asian real money investors insurance companies, growth of pension funds, private wealth) and increasing new demand from Chinese banks and corporates.
Asian Macro Backdrop – accommodative monetary policy backdrop to continue
Despite weakening of fundamentals, overall monetary policies in Asia are accommodative given a weaker growth backdrop and benign inflation. This means liquidity should remain relatively ample and baring a material negative credit event, most corporates will continue to have access to funding. Short-term liquidity of high yield corporates remains decent as debt profiles have been termed out. For example, Agile recently redeemed their 2017 bonds through cheaper funding of a longer-dated HKD syndicated loan.
Fed Rate Hike – a gradual rate hike cycle by the Fed is not disruptive
The US Federal Reserve (Fed) has recently sounded more hawkish so potential Fed rate hikes continue to be a headwind for markets generally. We believe the slower global growth environment will mean that the Fed will hike more gradually - a gradual rate hike cycle by the Fed is not disruptive to US dollar bond markets. Meanwhile, the European Central Bank and Bank of Japan will continue with quantitative easing. Overall, we expect interest rates in developed markets to remain low, notwithstanding the potential for a Fed rate hike in the months ahead.
Asian high yield bonds are less affected by a Fed rate hike as they trade more on absolute yield rather than spread. Asian high yield bonds also tend to have lower duration so the impact of a rise in yield is less compared to bonds with longer duration. Despite this, Asian high yield bonds are not fully immune to rising US treasury yields. As our approach actively manages portfolio interest rate risk, we monitor US Treasury yields levels closely and we would hedge interest rate risk with US Treasury futures if expectations for a Fed rate hike builds.
China Property – still seeing selective opportunities; policy remains overall supportive
China property makes up around 38% of the Asian High Yield universe (as per JP Morgan Asia Credit Index (JACI)-High Yield index). We remain constructive on the Chinese property sector. The drivers underpinning consumer confidence are linked to affordability – lower down payments, lower mortgage rates and higher income – with 57% of consumers experiencing a wage rise in the past 12 months. Importantly and uniquely for China, Chinese consumers are not highly leveraged into the housing market, with 78% of home owners having no mortgage on their place of residence. For those who have a mortgage, the mean Loan-to-Value ratio is just 41%. In additional, overall household debt in China remains low, at 40% of gross domestic product (GDP) in 2015. Property makes up around 18% of China’s GDP and up to 25% if we include related industries such as steel, transportation, cement etc. Given the importance of the property sector in the overall economy and the fact that property remains the main investment for many households (property accounts for over half of total household assets), we believe that in the event of a renewed downturn, the government would be forthcoming with increased fiscal and monetary support to prevent major financial stability.
We prefer property developers in the higher tier cities where the underlying end-user demand is stronger and inventory overhang is lower. We will invest very selectively in property developers in the lower tier cities where we see improvements and potential for ongoing inventory reduction. We focus on developers that have strong sales execution capabilities, prudent financial management, discipline in land-bank purchases and good liquidity profiles.