This is the reproduction of an article in IFR Asia magazine.

In the face of formidable uncertainties this year, investors may still seek the comfort of fixed income, says Dilip Parameswaran

Despite all the misgivings at the beginning, last year turned out to be a good one for fixed-income investors. Asian dollar bonds ended the year with a return of 5.8%, composed of 4.5% for investment-grade and 11.2% for high-yield bonds, according to JP Morgan Asia Credit Index data. We are beginning another year full of uncertainties. What does 2017 hold in store for fixed-income investors?

The first big uncertainty relates to the path of US interest rates. The Fed has begun raising rates and has signalled that three rate increases are in the offing this year and three more next year. A sustained period of job growth has brought US unemployment down to 4.7%, but more importantly the pace of wage increases to 2.9% per year. While these numbers underpin the Fed’s planned rate increases, the key unknown is the impact on any potential fiscal stimulus on growth and inflation.

That brings us to the second key uncertainty: the Trump administration’s plans for the economy. It is widely understood that the next administration intends to provide fiscal support through a cut in taxes and an increase in infrastructure spending, but the extent of the stimulus and its potential impact are unknown. If these plans start nudging inflation up to a level higher than the Fed’s current expectations, the Fed might have to respond by raising rates faster.

Another unknown is the extent to which the Trump administration’s policies on trade and the dollar will influence key economic variables. Mr Trump has espoused various protectionist views and may tolerate a weaker dollar. While a weaker currency might push inflation higher, the final impact of protectionist trade policies, particularly on growth and employment, is uncertain.

China is the other piece in this moving puzzle. At the beginning of last year, worries about China’s economy dominated the markets, but as time went on, growth began to stabilise and greater uncertainties – including the US presidential election – took over. This year too, the markets are resting on the comfortable assumption that China would manage growth of about 6.5%.

But China still faces a myriad of economic issues, all of them carried over from the last year. While economic growth last year was propped up by continued flow of credit to the economy, the total debt in the system has reached close to 300% of GDP, according to various estimates. China also faces the challenge of rising capital outflows in response to slowing growth and a depreciating currency. While property construction was a key support for the economy last year, property prices in many cities have risen to such unsustainable levels as to prompt a round of regulatory constraints. The government may provide a measure of support to the economy through an expanded fiscal deficit, but it would exacerbate the challenge of managing the total debt in the economy. On top of all these domestic economic issues, there is the added challenge of a strained trade and political relationship with the US. China may yet emerge as one of the key trouble spots this year.

Where does all this leave the fixed-income investor in Asia? We believe that Asian dollar bonds could again produce positive returns of 2%-3%, without leverage.

One key driver of the returns is, of course, US Treasury yields. Based on the current expectations for the Fed rates, we believe the 10-year yields could rise by about 50bp over the year to reach close to 3%.

The spreads on Asian dollar bonds narrowed by about 25bp last year for investment-grade and 130bp for high-yield bonds, according to the JACI data. This year, we expect investment-grade spreads to finish flat and high-yields bonds to widen by 50-75bp. This is primarily because the positive performance last year has left Asian spreads somewhat tight by historical standards and in comparison with US spreads.

Credit defaults are unlikely to turn into a big issue for Asian bonds. Moody’s expects that, after a temporary pick-up in the early part of the year, the global high-yield default rate will edge down from 4.4% to 3% over the year. In Asia, defaults have always been episodic and not systematic. Given the prevalence of family ownership, government connections and bank support, Asian issuers have averted defaults in many difficult situations.

The technical factors for Asian bonds were strong last year. Nearly three-quarters of Asian bond issues were placed within Asia, up from 63% the year before. Support from Chinese investors in particular has been one of the contributing factors. We expect these factors to continue supporting the market this year as well.
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While some market players expect a wholesale shift of funds to equities this year, the so-called “great rotation” has so far proved to be the wolf that never came. With major uncertainties confronting the economic world this year, investors might yet prefer the cosy comfort of fixed income for a while yet.

This is the reproduction of an article in IFR Asia magazine.

One of the key constraints for the Indian economy is the accumulation of non-performing loans in the banking system. Recent figures from the IMF show that, at 5.9%, India’s gross non-performing loans as a share of total loans are the highest in Asia. Including restructured loans, the figure exceeds 14%.

As banks groan under this burden, they are unlikely to be able to support the lending growth required for the economy to pick up. The Reserve Bank of India has taken the first step towards a solution by conducting asset-quality reviews and insisting that all the non-performing loans be recognised for what they are. It has imposed a deadline of March 2017 for the banks to properly classify loans and make provisions.


While this may increase the stress on the profitability and capital ratios of the banks, it is better to accept the truth than to brush it under the carpet. The capital ratios of Indian banks are already among the lowest, according to IMF, and will come under further stress as the banks go through the inevitable pain. While the government has allocated some funds to recapitalise banks, this is by no means sufficient.

Apart from pushing for greater transparency, the RBI has allowed banks to convert loans into equity with a stipulation that they have to find a buyer for the shares within the next 18 months. The challenge for the banks is to convert the debt to equity at a high valuation, manage the companies in the interim, and identify a buyer. The RBI permits the banks to sell as little as a 26% stake while holding the rest, but potential buyers may not like keeping the banks as co-owners for an extended period.

The RBI has also allowed banks to refinance loans to the infrastructure sector for 25 years with refinancing or restructuring every five years. The question is whether banks will apply this option to viable loans or to mask problems.

However, none of these solutions is a genuine attempt to improve the viability of troubled borrowers. If India’s bad loan problems are to be resolved in a meaningful way, a host of supporting systems need to be developed. The recently enacted bankruptcy law goes some way in offering solutions for the resolution of insolvent companies, but more changes are required.

First of all, banks need the freedom to deal with problem loans in the best way possible. Currently they are averse to writing off loans or to sanction additional credit for troubled companies for fear of being accused of underhand dealings. The current RBI regulations are far too constraining for them to try to revive distressed borrowers, as they impose a time limit on re-sales of equity shares acquired through debt swaps, lay down the equity valuation method, and specify the minimum percentage to be sold.

India also needs to develop a strong culture of evaluating credits before the loans are sanctioned and for monitoring the borrowers for early-warning signals of trouble. In this context, it is interesting to note that it is not small-scale industries that have led to this massive accumulation of bad loans, but the medium and large-scale borrowers. So the question can justifiably be asked why the banks tolerated the build-up leverage and not take action sooner.

The concept of independent insolvency professionals introduced in the new bankruptcy law is a positive move, but they need to come from a variety of industrial management, finance and turnaround backgrounds, rather than merely the legal profession. This will happen only if banks are willing to entrust management of troubled industries to turnaround professionals rather than lawyers with expertise in dissolving companies, backed by appropriate incentive structures. For example, banks may agree on an incentive compensation based on an objective measure of improving the value of the borrowers’ business such as a multiple of Ebitda or on specific actionable measures such as completion of specific projects.

Although asset reconstruction companies have existed in India for many years, they are modest in size compared to the scale of the problem. They have also enjoyed a favourable system of putting up a cash outlay of only 5% (recently increased to 15%) and charging a management fee of 1.5%-2% of the asset value. In addition to this model, other models of outright sales, incentive payments and sharing of recovery values would encourage reconstruction companies to maximize recoveries. Unlike China, India could also consider investing public funds in asset reconstruction companies in order to provide a speedier resolution to the problem.

​Any amount of tinkering with rules on recognition of problem loans and provisioning is not likely to lead to a genuine revival or resolution of bad loans. To achieve that, the mindset has to change across the entire range of stakeholders, including banks, turnaround funds, professionals, and even the government.

This is the reproduction of an article published in the IFR Asia magazine.

Asian bonds are yet again likely to generate positive returns this year and provide a measure of stability to investors’ portolios, says Dilip Parameswaran

The year has not exactly started well for many asset classes. Oil has sunk to prices not seen in the last 12 years. With another sudden downward lurch in its currency, China has injected more concerns into the market about its economy, dragging other commodities further down. Equity markets have taken fright, with the Dow already down 9% since the start of 2016.

Against this background, there is one question on the mind of every investor: “With the Fed poised to raise again this year, what does the future hold for fixed-income investments?” In our assessment, the answer is not as negative as you might think: US dollar bonds from Asia can generate a total return of 2%–4%, without leverage.

Last year, Asian bonds generated a total return of 2.8%, split into 2.2% for investment-grade and 5.2% for high-yield bonds, according to JACI index data. This year’s returns are likely to be on a par with those.

When considering the outlook for this year, the first point to appreciate is that Asia is still an attractive growth story. China’s economic slowdown being partly compensated by India’s pickup, Asia ex-Japan is still set to grow at 5.8% this year and next, according to the IMF’s forecasts. This stands in stark contrast to the outlook for other emerging markets, which are suffering from a mix of problems, including low commodity prices.

THIS YEAR’S EXPECTED total return from bonds depends on many moving parts. The first is, of course, the likely increase in the Fed funds rate and the medium-term Treasury yields. Economists hold different views on how much the Fed would raise the target rate. Some point to the persistently low inflation, others talk about falling unemployment, and some highlight the potential for global issues (including China) to slow the pace of rate increase. But overall, the Fed funds futures are currently pricing in a Fed funds rate of 0.6% for the year-end. That indicates the potential for medium-term Treasury yields to rise less than expected, perhaps by 50bp.

The second key element is the credit spreads. According to the JACI data, the average Asian bond at the end of 2015 traded at 293bp over swaps, broken down into 222bp for investment-grade and 596bp for non-investment-grade. These spreads are eight times the pre-crisis levels for investment-grade and over six times for non-investment-grade. Although one may argue that the pre-crisis levels reflected unjustified and unsustainable exuberance, the current levels are still higher than the post-2009 average spreads by about 25bp for investment-grade and 140bp for non-investment-grade.

Compared to the US credit markets too, Asian bond yields are still higher, by about 90bp for investment-grade and 50bp for high-yield.

In our view, the current spreads reflect neither a significant overvaluation, nor undervaluation. Consequently, they indicate the potential for the spreads at the year-end to stay close to their current levels, perhaps within 20bp.

The third determinant of returns is defaults. At a global level, high-yield default rates are likely to pick up: Moody’s expects the global high-yield default rate to reach 3.7% by November 2016, a level that is higher than the 3% for last year, but still lower than the longer-term average of 4.2%. In Asia, most of the defaults have been triggered by the crash in commodity prices and the economic slowdown in China. These factors are likely to keep Asia’s default rates elevated, but should not lead to a spike.

THE TECHNICAL FACTORS for Asian bonds are likely to be supportive this year. Already, many major issuers have turned to Chinese domestic bonds instead of US dollars, as it offers them cheaper funding and reduces their currency risk. This year’s supply of new bonds is also likely to be restrained by the same trends, particularly in the China high-yield sector.

At the same time, the demand for bonds has remained strong, in particular from the institutional investors in the region, who picked up 63% of new issues in 2015, up from 58% in each of the three years prior to that. For most investors, Asian bonds have become a mainstream asset class, rather than a frontier asset class; and they are likely to maintain their presence in Asian bond markets in the medium- to long-term.

Based on these factors, we expect Asian bonds to generate total returns of 2%-4% if five-year Treasury yields rise by 50bp. Even if the five-year rates rise by 75bp, which seems aggressive given the uncertainties surrounding further rate increases, Asian bonds can still generate positive returns in the range of 0.7%-3%.

Given the higher yields and lower duration, high-yield bonds on the whole are likely to generate higher returns than investment-grade bonds by about 200bp in the base case. However, the challenge for investors is likely to be one of avoiding the potential defaulters. That is no easy task, since the defaults are triggered not only by economic, but sometimes by political factors as well. Another challenge of investing in high-yield is the lower liquidity due to the shrinking capacity of banks to hold inventories and make markets.
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In an environment of so many uncertainties – including those around the Chinese economy, commodity prices and geopolitical risks – we believe investors should maintain a reasonable allocation to fixed income to provide stability to their portfolio returns.

This is the reproduction of an article in IFR Asia.

Investors in Asian bonds got an unwelcome gift on New Year’s Day: Chinese property developer Kaisa Group announced that it had defaulted on a loan from HSBC.

The Kaisa tragedy had been unfolding since early December, when the company first halted trading in its shares and announced that Shenzhen authorities had blocked sales at three of its projects. Sino Life, an insurance company based in Shenzhen, then stepped in with US$215m to raise its stake from 18.75% to 29.96%, raising hopes that the bans would be soon removed. Even when Kaisa’s chairman resigned on December 11, there were no immediate concerns over Kaisa’s liquidity, based on the company’s last reported cash balance of Rmb11bn (US$1.75bn) at the end of June 2014.

Since then, however, there was a barrage of negative developments that neither Kaisa nor Sino Life could staunch. Shenzhen expanded its restrictions on Kaisa, onshore banks began legal proceedings to freeze Kaisa’s bank balances and assets, some project partners began to cancel their joint ventures and demand refunds. By the end of the month, the CFO and the vice chairman had quit – an important development since they had been key contact points for the financial market.

Yet, there was no actual default – until January 1st when the company announced that it had failed to meet HSBC’s demand for immediate repayment of a HK$400m (US$51.5m) loan due to the earlier resignation of the company’s chairman. After that, the company failed to repay an onshore trust loan. The offshore US dollar bondholders were directly affected on January 8, when the company did not pay a US$23m coupon. These amounts were trifling when compared with its June cash balance, but the company could still not meet them.

Throughout this saga, Kaisa’s offshore US dollar bonds fell to a low of about 30 cents. They have since recovered to about 60-70 cents after Sunac China, another property company, agreed to take a 49% stake and Kaisa paid the coupon within the 30-day grace period. The company has appointed a financial advisor and the market hopes that the restructuring of the bonds would not be too onerous on the investors.

Even as the Kaisa story has yet to reach its denouement, it is likely to have long-lasting implications. To start with, Kaisa may well turn out to be the first default in the Chinese property sector if the proposed restructuring of bond terms turns out to be a haircut in disguise. Previously, there have been several close shaves, but only three other property companies (Greentown China, SRE Group and, currently, underground mall developer Renhe Commercial) have bought back their bonds at 80-85 cents, widely seen as reasonable levels.

But Kaisa is also the first offshore bond issuer whose downfall was triggered by the actions of a local government in China. While no one has a full explanation of the actions of the Shenzhen authorities, the way the restrictions were expanded to cover multiple aspects of the business sent a clear message that the government intends to take strong action against Kaisa.

This means that investors have to assess not only business risks, but also pay specific attention to corporate governance risks. The Kaisa case has indeed taken them by surprise, as there had been no major corporate governance problems in the property sector so far. Agile Properties had alerted investors to the potential for such problems late last year, but they had been reassured when Agile had taken quick and firm measures to raise equity from the controlling shareholders’ family and demonstrate the support of its banks.

In the meantime, the cost of capital for the sector has increased sharply since late-November. (See Table.) While some of this increase may be reversed later this year if the property sector recovers, new debt raised in the meantime will have to bear this increased cost.

Excluding Kaisa, about US$2bn of offshore bonds (US dollar and CNH) from China’s property sector are due for repayment in 2015. As financing conditions tighten, not all issuers may find it easy to refinance maturing bonds. The Kaisa issue has made it more difficult for lower-rated borrowers to raise financing at a reasonable cost.

It is also possible that investors would demand tighter covenants on future high-yield bond issues from China. For instance, offshore interest reserve accounts would be one way to address the split between onshore and offshore cash balances – a key concern in times of stress. Such reserves would give issuers and investors more time to sort out problems instead of pushing the issuers into immediate defaults. Investors may also begin to look critically at definitions of change of control and perhaps demand listing suspensions to be included as events of default.

While the underlying structural subordination of offshore bonds is likely to persist for a while, Kaisa has made investors painfully aware of the vulnerability of their position. So far, offshore bondholders have not had an opportunity to test how they would fare in a Chinese property bankruptcy. Let us hope Kaisa will not give them that chance.

The first challenge facing Asian credit is the global economic backdrop. The most important hurdle this year is the impending rise in US interest rates and its impact on asset markets. Although the consensus is for rates to finally start rising in the third quarter, the potential pace of that increase is unclear, particularly in the face of the stubbornly low inflation.

In Europe, growth is stalling even for countries with strong balance sheets, and the economy is inching closer to deflation. Greece’s sudden elections may trigger renegotiations with other eurozone countries and raise the spectre of a currency breakup. Japan remains an experiment in progress, with the success of Abenomics far from assured in the face of faltering growth and sluggish exports.

By contrast, the economic picture in Asia is much brighter. Although various indicators have repeatedly shown that the Chinese economy is slowing, there is enough room for fiscal and monetary relaxation to maintain a growth rate close to 7% for 2015. India’s new government faces a rare confluence of positive factors. Lower oil prices will bring the current account closer to balance and reduce inflation, enabling interest rates to be cut and fuelling a pick-up in growth. The new government in Indonesia has also begun to take difficult decisions to cut fuel subsidies and devote more funds to infrastructure development. Its reform agenda is likely to support a gradual uptick in growth.

Overall, the International Monetary Fund forecasts Asia ex-Japan to maintain its growth steady at 6.3% for 2015, beating the outlook for other emerging regions, including Russia, Eastern Europe and Latin America and attracting investors to raise their allocations to Asia.

ACCORDING TO THE JP Morgan Asia Credit Index, Asian spreads ended 2014 exactly where they started: 262bp. While investment-grade spreads ended up at 188bp, just 8bp tighter, non-investment-grade spreads widened modestly by 58bp to end at 534bp.

At the current levels, Asian spreads are still much wider than before the 2008 global financial crisis: investment-grade spreads are more than double (188bp versus 83bp) and non-investment-grade spreads are more than thrice the pre-crisis levels (534bp versus 167bp).

In comparison to US spreads, Asian investment-grade corporate bonds provide a yield pick-up on average of 120bp, and Asian non-investment-grade corporate bonds pay 190bp more at the same rating and maturity. While some of this may be attributed to poorer liquidity, more complex legal systems and macroeconomic vulnerabilities, it still indicates the premium that Asia can provide.

Although the year has begun with a potential bond default by China’s Kaisa Group, a multitude of defaults through the year is unlikely in view of the reasonable economic growth and sustained liquidity for refinancing. The gradual relaxation of property policies in China should also support the Chinese property sector.

International bond issues from Asia hit a record of US$210bn last year, and there should be no problem in finding buyers for another year of heavy supply. One positive development in the last five years has been the superior ability of Asian investors to absorb Asian bonds, taking 57%–58% of last year’s new issues, up from 40%–45% of a much smaller volume pre-crisis. While the share of retail investors has declined (to 10% last year from 14% in 2013 and 16% in 2012), institutional investors have stepped up to absorb the ever-increasing supply.

That brings us to the question of what will happen when interest rates start rising. Based upon previous rate cycles, there is no evidence to support an automatic widening or narrowing of credit spreads; rather, spreads depend on the prevailing macro and credit environment. For example, in 1993–94, as the Fed raised rates by 300bp, average BBB credit spreads declined by about 30bp; in 2004–06, when the Fed raised rates by 425bp, spreads fell 80bp.

GIVEN THE REASONABLE economic growth, subdued default rate, higher spreads in Asia and the growing investor base, our base case is that Asian spreads would contract by about 20bp this year, delivering a total return of about 3% assuming five-year Treasury yields rise about 70bp. While this is lower than last year’s total return, it must be remembered that about 60% of last year’s return came from falling Treasury yields, a supporting factor unlikely to be repeated this year.

However, our forecast is not meant to rule out high volatility or idiosyncratic risks during the year. If oil and commodity prices continue to decline, or if the Russian situation gets worse, emerging markets in general could suffer and a contagion effect could reach Asia as well. While it stands to reason that Asia would be a net beneficiary of lower oil prices, and investors should be able to differentiate Asia from other emerging markets, volatility may still affect valuations in the interim.

Europe still has the potential to emerge as a significant source of volatility, if either Greece were to depart the currency union, or QE fails to revive growth and lift inflation. Closer to home, China could roil the markets, too, if it struggles to rev up its economy or if Chinese local-government debt becomes a challenge.

The consolation in these cases is that the Fed might be pushed to slow the pace of rate increases, and equity markets may perform worse than expected, again prompting higher allocations to fixed income.

Within Asian credit, although we are tempted to say that high-yield bonds would outperform investment-grade bonds in view of their higher carry, volatility in high-yield is likely to be much higher this year and one or two mistakes could wipe out the returns from a high-yield portfolio. Individual risks have risen in Chinese property, and some lower-rated issuers may find it difficult to refinance their maturing bonds. Issuers from the resources sector from Indonesia and China are at risk of a further slide in commodity prices. Subordinated debt issues from banks are also pressuring higher-rated high-yield bonds. Our preferred strategy is to overweight investment-grade, while maintaining an exposure to high-quality high-yield names.

This is the reproduction of an article in IFR Asia.

To many global investors, bonds from China’s property sector are toxic nuclear waste, not to be touched at any cost. To others, they come with a more pragmatic “handle with care” warning. I belong to the latter camp.

From just a handful of bonds 10 years ago, the sector has grown to contribute 9.5% of the Asian US dollar bond market with US$51bn of bonds trading. That is nearly a third of all high-yield corporate bonds in the region.

Over this period, the sector has gone through three cycles of downturns and upturns. Several Chinese property companies have issued, redeemed and refinanced their offshore bonds. Companies with credit ratings ranging from Single A to Triple C have managed to issue bonds, which trade actively in the secondary market. Yet, a feeling of unease persists.

Perhaps the first source of discomfort is the fact that offshore Chinese property bonds are deeply subordinated, since they are issued by offshore-incorporated entities, which inject the bond proceeds as equity into their onshore companies and service their debt only out of equity dividends received back from the mainland. The difficulties in repatriating equity funds out of China mean that the offshore principal effectively has to be refinanced. In case of bankruptcy, the onshore lenders have the first claim over the onshore assets.

While this structural weakness is undoubtedly true, it applies to every other bond issued by Chinese businesses, including investment-grade bonds far beyond the property sector, since the structure was born out of regulations prohibiting the issuance of debt or guarantees by mainland companies. (Only recently have the authorities begun to relax this prohibition, and the first few offshore bonds are now coming out with direct guarantees from mainland operating companies.)

ANOTHER SOURCE OF discomfort is the government’s meddling in the property sector through various measures, including the flow of credit to the builders, rules for financing land purchases, obtaining mortgages, and mortgage down-payment requirements. The harshest controls came in 2010 when the government restricted the number of apartments that an individual could purchase.

Property prices are a sensitive subject everywhere, and China is no exception. The government presses the brakes if the prices are speeding too fast and pushes the accelerator if property construction flags too much so as to threaten the overall economic growth.

This government intervention makes asset values volatile in both equity and debt markets, and raises the cost of capital to the sector.

Some investors have also been scared away by stories of oversupply and ghost cities. The property development business model, by definition, consists of a long operating cycle, and there may be genuine demand/supply imbalances, as in any other industry, but the overwhelming majority of Chinese properties are built in response to actual demand from a rapidly urbanising population. The same goes for talk of speculative buying, when the reality is that most of the properties are bought for self-occupation. Buyers have to put up a minimum 30% down-payment, they are not over-leveraged and there is no subprime lending.

WHEN IT COMES to investing in Chinese property bonds, one should realise that there has already been one level of filtering – only those companies large enough to go through a rating process and the expense of issuing offshore actually end up selling dollar bonds. They are all listed offshore, most of them in Hong Kong, and are subject to audits and disclosures that go with the listing status. The additional scrutiny from equity analysts and investors that comes with listing also offers additional information for bond investors.

There has not been a single default in the sector so far, and only two distressed exchanges in 2009, both at 80 cents to the dollar. Some companies did go through financial distress during previous sector downturns, but they managed to sell land or unfinished projects to stronger players and stave off default.

This is not to argue that we would never see a default in the sector. We will, sooner or later. But the sector has genuine fundamentals, strong and weak players, and saleable assets that can be realised in times of distress.

So, how should one approach investments in Chinese property bonds? First of all, investors need to be prepared for the volatility that comes with the regulatory changes. Any crash in value following a regulatory tightening offers an opportunity to pick up the higher-quality bonds at more attractive prices. In fact, such moves also enable the stronger players to buy out the weaker ones or to acquire assets from the struggling players, and increase their market share.

The current downturn in the market is no different. It is true that the stock of unsold property is running above average; that the leverage has increased in the last 12-18 months in response to slowing sales; that margins are under pressure due to the pressure to liquidate stock; and that some of the weaker companies are likely to experience a liquidity crunch in the next 12-18 months, unless they slow down their expansion. But the current downturn is also an opportunity to pick up bonds issued by stronger companies, which will benefit from the tight conditions in the sector. The challenge is reading the credit fundamentals carefully enough to identify the winners.

This is the reproduction of an article in IFR Asia.

Asian bonds have had a good run so far this year, producing a total return of 7.8% according to J.P. Morgan Asia Credit Index (JACI). But, looking back over the last three years, yields and spreads have steadily declined, so much so that “high yield” has become an oxymoron!

That has raised the question in the minds of many people: Is there a bubble in Asian fixed income?

The “B” word has been applied variously to different asset markets, such that it has become an amorphous thing … one that everyone talks about all the time, but no one knows precisely what it means!  Let us try to keep the dreaded word in perspective for our discussion. One definition of a bubble is when the prices are far in excess of the fundamental value of the assets. Another way to look at a bubble is as an unsustainable and fast rise in prices. Either way, a bubble carries the potential to hurt investors when it eventually suddenly bursts.

Keeping this in mind, let us examine the evidence in the Asian U.S. Dollar bond markets. The first evidence for the existence of a bubble is the contraction in both yields and spreads. It is true that the current yield to maturity of 4.6% for JACI seems too tight, particularly when compared with the high level of 11% during the Global Financial Crisis. But if we disregard the spike in yields during the GFC and the period when the interest rates were slashed in its aftermath, average yields have moved in a narrower range of 4.2% to 5.5% in the last four years and the current yield is near the middle of this range.

Similarly, if we consider the history of spreads, the current spreads over Treasury of 243bp appears tight when compared with the GFC high of over 800bp. But in the last four years, they have ranged between 214bp and 450bp; and if we disregard the mini-spike during the European sovereign crisis, they have moved between 214bp and 320bp. Compared to this range, the current spreads do not appear so alarming. In fact, they are more than double the tight levels of 109bp reached in 2007 before the GFC.

Compared to the U.S. domestic bonds, Asian spreads still offer value. Asian investment-grade corporate bonds, for example, trade at 180bp over Treasury, while spreads for U.S. industrial bonds with equivalent credit quality and maturity trade at spreads of 100bp.

When we consider the fundamentals, another key factor is the default rate for bonds. According to Moody’s, the global high-yield default rate was 2.1% for July 2014, well below the historical average of 4.7%. In Asia-Pacific, Moody’s predicts a default rate of 3.3%.

While such low default rates are one of the supports for the current tight spreads, we must remember that they are themselves partly the result of loose liquidity conditions and easy monetary policy. That brings us to the one of the key reasons to question whether the Asian bond market might collapse in a bubble-like fashion when rates start rising and liquidity begins to ebb. It is doubtless true that the bond valuations have benefited from the falling rates. In 2014 so far, of the 7.8% return generated by Asian bonds, 3.6% has come from a fall in Treasury yields and the rest from tightening spreads.

This comfortable environment would change as the Fed starts raising rates in the second half of 2015. Not only will longer-duration bonds face capital losses, but weaker companies would find it more challenging to roll over maturing debt – in turn leading to higher default rates.

It is based on such fears that some predicted a mass migration of funds from fixed income to equity, calling it the Great Rotation. But so far, in the Asian bond markets, there has been scant evidence of such a shift. New issue volumes are touching record levels, with USD 120 bn of new bonds so far this year, representing a growth of 35% over the same period last year. Although private banks have taken up only 9.7% of new issues this year, down from 16.2% and 13.9% in the last two years, the gap has been more than adequately filled by institutional funds.

At a very fundamental level, Asian economic growth is holding up reasonably well, although all eyes are on China’s and India’s growth rates to see how these two economies perform. For the Asian bond market, China is a key variable, particularly the Chinese property sector.

So, finally, is there a bubble or not in Asian bonds? Although Asian bond valuations are stretched at the moment, they are not beyond belief and entirely divorced from fundamental factors. Some of the supporting factors such as rates and high liquidity will diminish over the next two years, but I believe the correction would be orderly and not a sudden collapse. Asian bond valuations may be tight, but they are not a bubble.

One year ago, when Bernanke first mentioned the possibility of tapering, the asset markets took fright that the Fed would take away the punch bowl. The U.S. Treasury yields spiked immediately, leading many commentators to predict an Armageddon in the fixed-income markets resulting from a combination of rising rates, falling asset prices, shifting of funds to equity markets.

However, the reality so far has turned out to be very different. As the Fed began the actual tapering, interest rates have gone down this year. The 10-year Treasury yields ended the last year at 3%, but have since retreated to 2.6%, reflecting the hesitant performance of the U.S. economy as well as the additional monetary stimulus from Japan and the possibility of a stimulus from the ECB.

Neither has the “great rotation” out of fixed income into equities materialized. The equity funds covered by EPFR have received USD 46 bn of inflows this year, while the bond funds have gathered USD 84bn. It is interesting to note that both figures are lower than those recorded in the same period last year (USD 140 bn for equity and USD 100 bn for bonds). However, these figures mask a striking contrast between developed-market and emerging-market funds: the former gained USD 68 bn in equity and USD 90 bn in bonds, while the latter lost USD 23 bn in equity and USD 7 bn in bonds.

If one were to observe the Asian USD bonds, however, one would certainly believe that the good times are still rolling on. New bonds worth USD 80 bn have been issued in the first five months of 2014, at par with the corresponding period of last year. (Note that the chart below includes EUR and JPY as well).

Asian USD bonds have so far produced a total return of 5.6% (see table below), split roughly equally between the returns from the falling US Treasury yields and the tightening spreads. Split another way, coupons have generated about 2% so far, while rising bond prices (both due to US Treasury and spreads) have produced 3.4%. The table below shows that investment-grade has outperformed high-yield so far. This is mainly thanks to the concerns over the Chinese property credits and the impact of the falling coal prices on Indonesian mining credits. 

This total return looks quite respectable when viewed against the overall equity market performance. MSCI Asia ex-Japan equity index is up 2.8% this year, thanks mainly to emerging markets such as India. Hang Seng, on the other hand, is flat.

Regular readers of this blog may remember our recommendation for this year to overweight high-yield. We still expect high-yield to outperform investment grade. While we still believe in that prognosis, investors would be well advised to follow two other broad strategies:

• Stick to better quality names: While liquidity is still comfortable, there will come a day when companies with lower credit quality will find it difficult to refinance themselves. Already, bonds with lower ratings have underperformed: as the chart below shows, the best returns have come from “BBB” bonds, while the worst have come from “B” and “C” rated bonds.
  

• Control the duration: While the decline in the interest rates have taken many people by surprise, thereby enabling the longer-duration paper to do well, it is difficult to conceive of the rates falling further. In fact, discussions have already started in the Fed about when the first rate increase should take place. At this juncture, it is better to shorten the maturity of the portfolio towards five years rather than longer. Many perpetual bonds look increasingly riskier, unless the issuer has a strong incentive to call the bonds earlier.
  

Asian dollar bonds ended in the red last year with a total return of -1.3% according to the JP Morgan Asia Credit Index (JACI). However, this figure masks a large variation between different segments. At the low end, investment-grade sovereigns lost 8.2%, while at the high end, high-yield corporates produced a return of 4.3%. Within high-yield corporates, Chinese property credits were the best performers, earning a return of over 7%.

The negative return was mainly due to the pick-up in Treasury yields, particularly after May 2013 when talk of tapering emerged. Spreads on Asian bonds performed well, with the overall spreads steady at 260bp despite the ructions in market.

The outlook for 2014 will again be dependent on both Treasury yields and the underlying credit fundamentals. With the Fed poised to taper the quantitative easing over the course of the year, and as the US economy continues to accelerate, we can expect further increases in Treasury yields. After the 10-year Treasury yields have already touched 3%, they are unlikely to rise at the same pace as last year, and a rate in the mid-3% area for 10 years seems appropriate for the end of 2014.

Asian spreads are still higher than their pre-crisis levels (see chart below). In addition, the table below shows that Asian dollar bonds provide a yield pick-up over US bonds for same/higher ratings and shorter maturities. The yield pick-up is about 30-60bp for investment-grade and about 180bp for high-yield bonds. Given these factors, there is scope for a further contraction in Asian spreads by 25-50bp. This should cushion the impact of the expected rise in Treasury yields.

The other supporting factors for spreads are the likely low default rates and steady credit ratings in Asia. The underlying economic picture should also be supportive for credit quality – the US economy is likely to further pick up this year, Europe is expected to limp back to stability after recession, and Asia should be supported by the improving external economic environment.

If Treasury yields rise and spreads contract, the net effect could still lead to a positive return for Asian credits as a whole. The average yield on Asian bonds is 5.3%, composed of 4.6% for investment grade and 7.5% for high yield, according to JACI. As long as Treasury yields do not rise steeply, the overall return should be close to the yield. Of course, the net return depends on the extent to which Treasury yields rise.

For instance, if 10-year Treasury yields reach 3.5% and spreads contract 25-50bp, then the total return could reach close to 4%.

With the Asian credit universe, high-yield corporates are once again set to outperform investment-grade credits. High-yield bonds should do well as long as default rates stay low and the refinancing environment remains comfortable. Hence it makes sense to overweight high-yield bonds in Asia.

That brings us to the concept of the two interest rates: one that applies to the investments and the other to leveraging the portfolio. Over the course of this year, as the Fed tries to taper down its quantitative easing, longer-term interest rates are set to rise further, negatively affecting the market values of bonds. Hence, it is important for investors to focus their portfolios towards the short-to-medium-term maturities of, say, around 5-7 years.

The short-term interest rates, on the other hand, are likely to stay low, as the Fed will continue to keep the short-term rates close to zero for an extended period of time, perhaps until the end of 2015, and raise the rates only in small steps after that. Investors can use this to leverage their portfolios by borrowing short-term funds.

There is one final element in the construction of the portfolio strategy in Asian credit, and that is to choose credits carefully with regards to their fundamentals. While the refinancing environment may be reasonably easy in 2014, the same cannot be said of the years after that. As liquidity tightens in 2015 and as cost of funds rise, not all the borrowers will find it easy to refinance maturing debt. That in turn could lead to mark-to-market losses for weaker credits, perhaps later in 2014 or beyond. Investors must position their portfolios by carefully avoiding such weaker credits.

So, let’s put together the main elements of the suggested investment strategy in Asian credits:

1. Keep the portfolio maturity towards the lower end, i.e., 5-7 years.
2. Continue to employ leverage to improve returns.
3. Overweight high-yield over investment-grade.
4. Choose the credits carefully and avoid fundamentally weaker credits, even if their yield is attractive.

By carefully managing the portfolio, it is possible to generate returns of up to 8-10% from Asian dollar bonds for 2014. 

Last week, I participated in three panel discussions in the South East Asia Borrowers and Investors Forum in Singapore. In my panels and throughout the conference, one word kept reverberating: “Tapering.” Unknown and unused in the financial markets previously, the word has acquired a magical significance ever since Bernanke uttered it in May.

The fear of tapering took a slightly different form in the context of local-currency bonds as opposed to USD bonds from Asia. In case of USD bonds, the question was the potential for fixed income as an asset class to produce returns in the face of rising rates; in case of local-currency bonds, the issue was linked to the potential for fund outflows from emerging-market economies, triggering volatility in currencies, equities and bonds alike.

Over the next few months, there are many flash points for emerging markets, including India, Indonesia and Brazil. The first is the next round of negotiations in the US for the debt ceiling in January. Then comes the potential beginning of tapering by the Yellen Fed, some time in the first quarter. After that, the national elections in India (before May 2014), the presidential elections in Indonesia (July 2014) and the general elections in Brazil (October 2014). Each of these events has the potential to keep alive the volatility that we have witnessed this year.

The current mood in the fixed-income markets is one of relief (that the tapering is not imminent) mixed with foreboding (that rates are eventually set to rise further). At the moment, the market is still in a healthy state, as evidenced by the flow of new issues and the stability in credit spreads.

Beyond the next few months, the shape of the fixed-income markets will depend on the speed with which interest rates normalize. I believe that even when tapering gets underway, it will be a carefully managed process by the Fed. The Fed has made it abundantly clear that any withdrawal of monetary stimulus will be data-dependent. The Fed has a lot of leeway in deciding the speed of tapering. While it may start with a reduction in QE of USD 10 billion a month, it may not continue to taper at a rapid pace if the economy begins to falter. The Fed will also be watching the behavior of long-term rates, both as an indication of the market reaction, and more importantly, as a key variable that could affect the mortgage rates and the housing recovery.

As a result of this carefully managed process of tapering, fixed income investors should be able to adjust their portfolios over the medium term. If there is a sudden jolt to the rates, like it happened during May-June 2013, leading to losses in the portfolio, there is likely to be a temporary pullback. If rates adjust gradually, over the next 2-3 years, there will be enough breathing space for investors to realize their maturing investments and reinvest them at higher yields, and thereby adjust their portfolios for rising rates.