Asian High Yields: Separate the wheat from the chaff

The returns from Asian high yields are likely to come from carry and modest spread tightening in 2020, as the tailwind from the decline in treasury yields appears largely behind us. While green shoots are emerging in the global economy, rigorous credit selection will still be required to benefit from high yields’ attractive valuations and favourable supply dynamics.

Asian high yield (HY) bonds delivered more than 10% returns in 20191, benefiting largely from price gains that resulted from the 97 basis point decline in the 10-year US treasury bond yield. With the 10-year US treasury yield at 1.712% and signs of green shoots emerging in the global economy, the room for treasury yields to fall significantly lower appears limited. As such, Asian HY bonds may need new return drivers in 2020.

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New seeds of growth

We believe that the returns from Asian HYs will come largely from carry and modest spread tightening in 2020. At the point of writing, Asian high yields offer more than a 200 basis point spread pick up over their US peers. The spread differentials between Asian HYs and Asian Investment Grade bonds have also widened to above 400 basis points, back to December 2018 levels. Spreads can potentially tighten if the outlook for the Asian economy stabilises in 2020.

For now, the economic slowdown in Asia appears to be bottoming. South Korea, historically a bellwether for global trade and manufacturing, reported a smaller contraction in export growth in November and a modest year to date tick up in export volumes (+0.7%). Korea’s Ministry of Trade, Industry and Energy expects exports to grow from 1Q20 as demand of semiconductors, autos, and petroleum products improve on the back of a potential de-escalation in US-China trade tensions. The narrative appears similar for most of Asia’s trade-dependent economies. That said, the pace of the economic recovery is expected to be gradual.

According to the International Monetary Fund, Emerging & Developing Asia is expected to grow 6.0% in 2020, marginally above the 5.9% forecasted for 2019. Inflation is also expected to inch higher from 2.7% to 3.0% but unlikely to be worrisome except in selected countries such as India3. Current consensus estimates of an 11%4 earnings growth for Asian corporates in 2020, albeit from a low base, suggest that company fundamentals should improve. This potentially bodes well for HY bonds as they, like equities, are strongly linked to company fundamentals. Historically, HY bonds have a higher correlation to equities than to other fixed income sectors. See Figure 1.

Fig 1. Correlation of Asian HY corporates to selected asset classes5

Separate_the_wheat_from_the_chaff_fig_1

Should the green shoots fail to translate into a more sustainable recovery and the outlook for the economy turns challenging again, the income-characteristics of HY bonds are likely to come to the fore. This should provide investors with some defensiveness in their portfolio.

China in the spotlight

China almost reached another record year of onshore bond defaults as the economy slowed in 2019 and credit conditions tightened. At the point of writing, total defaults have reached USD17.1 billion6. While the defaulted amount is small relative to China’s USD4.4 trillion onshore corporate bond market, it has fuelled investor concerns of potential contagion.

With China accounting for more than 50% of the Asian HY bond market, HY investors cannot ignore but must navigate this market. It is important to note that not all China bonds should be tarred with the same brush. There are issuers with stronger financial profiles which provide good carry opportunities for investors. We also see selected opportunities in bonds which may have been unjustifiably sold down by market fears. The key to navigating this market is through rigorous bottom-up credit research in order to separate the wheat from the chaff.

From a sectoral perspective, for example, while the energy, consumer and retail companies have increased their leverage over the course of 2019, the leverage in the China HY property sector has remained largely stable7. This is partly due to the curbs by the National Development Regulatory Commission (NDRC) in July 2019 to restrict new offshore bond issuances for refinancing purposes only. This has in turn helped to discourage aggressive land acquisitions and stabilise credit fundamentals.

We expect the bifurcation between the bigger (who are experiencing slower growth) and smaller (who have big boy ambitions) property developers to continue. China’s restrictive housing policy in 2019 has pressured property sales and cash flows. Larger developers are likely to have better access to funding given their adequate liquidity position and ample landbank which can be pledged to secure financing.

Meanwhile, the higher earnings visibility of Chinese HY property companies makes them more attractive than HY Local Government Financing Vehicles (LGFVs), which have been in the spotlight recently as an increasing number of LGFVs experience financial woes. Investors will thus need to be selective and carefully assess the Chinese government’s willingness to stand behind distressed LGFVs when investing in this sector.

Beyond China

Despite the negative news headlines from China, the overall default rate for the Asian HY bond market is low (1%) for 2019, below that of Latin America (1.6%) and the Middle East (1.6%)8. That said, Asia’s HY bond default rate is expected to rise to 2.3% - 4.5% in 20209, although we take some comfort that Asia’s covenant quality is still higher than that of the other regions. See Fig 2.

Fig 2. Covenants for Asian bonds are stronger compared to other regions10

Separate_the_wheat_from_the_chaff_fig_2

Outside of China, we see opportunities in the Indonesian HY non-resource sector such as companies in the utility and property sectors. These sectors should stand to benefit as President Joko Widodo strengthens his coalition and pushes through more reforms. While the resource sector may languish due to the current low coal/commodity prices, we will take advantage of opportunities in selective companies where we feel that the market has punished excessively.

Over in India, the economy’s sharper than expected slowdown and tighter onshore liquidity are likely to weigh on Indian corporates’ balance sheets. That said, there is rising global appetite from ESG funds for bonds issued by green or environmentally-conscious issuers. Furthermore, with India’s goal to more than double energy generation from renewable sources, debt offerings from Indian alternative energy companies are likely to increase. We have thus seen Indian renewable energy firms issuing about USD3.4 bn of foreign-currency bonds in 2019, from none in 201811.

In general, within the Asian HY bond complex, we prefer single B over BB names given their better yield pick-up and more attractive valuations.

Still hardy

It is too early to call for blue skies and sunshine despite the green shoots we are seeing in the global economy. Divergent access to funding can weigh on weaker bond issuers.

In our 2020 Fixed Income market outlook, we noted that Asian HY bonds should continue to be supported by attractive valuations and favourable supply dynamics - gross issuance of Asian USD HY corporates is expected to fall 33% in 202012. The strong demand for bond carry amid the low interest rate environment is also another important positive for Asian HYs. With rigorous credit selection, investors should still be able to enjoy decent risk-adjusted returns from Asian HYs in 2020.

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