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 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 a recent article in IFR Asia.

While the world’s attention was focused on Greece’s negotiations with its lenders, another crazy spectacle was unfolding on the other side of the world. After running up 150% in the 12 months to June 12, the Shanghai stock market plunged by nearly a third in the next month.

There had been no fundamental reasons for the exuberance. China’s economy had in fact been slowing, with GDP growth at 7% in the first two quarters, down from 7.4% for the last year. The property sector, an important contributor to the economy, had also been struggling, with both volumes and prices showing a marked slowdown. Corporate profitability had been squeezed and unofficial estimates of non-performing loans in the Chinese banking system had been rising. The central bank only started cutting rates in November 2014, by which time the rally was already in full swing.

On the contrary, the run-up had been related primarily to a significant flow of financing to the stock market through a variety of channels: margin financing, collateralized lending, shadow financing through trusts, and direct peer-to-peer lending. While the overall value of borrowed funds in the stock market is difficult to judge, some estimates put the value as high as a third of all floating shares.

This diversion of funds could be in part a result of cooling property markets. As the property markets began to cool, the private savings that had been invested in it through shadow-banking channels began to be diverted to lending against stocks, in search of returns in the high teens.

Retail investors got caught up in the frenzy in the late stages of the rally, helping push the markets even higher. According to reports, more than 80 million retail broking accounts were opened towards the end of the rally.

As the market crashed, there was panic all around. Listed firms chose to suspend trading on their shares (nearly 50% of the Shanghai index was suspended at one point), and investors tried to cash out. But regulators panicked too. They organised a coordinated rescue by injecting Rmb120bn, first tightening and then relaxing the rules for margin financing, stopping IPOs, and changing the rules for opening of trading accounts. The central bank also announced another cut in interest rates, and authorities are now looking for foreign funds that might have shorted the market (and have started suspending some trading accounts of foreign fund managers). The stock market then went through several days of further volatility, but the precipitous crash had been arrested.

WHAT IMPACT IS the recent stock volatility likely to leave in its wake – assuming that the worst is indeed over for now? First of all, there is no doubt that faith of the common man in the stock markets has again been shaken, making Chinese investors question the viability of the equity market as a repository for their savings, at least in the medium term.

What China needs in the long run is to develop the equity market as a stable avenue for financing for businesses, particularly private-sector companies and small and medium enterprises. At the end of 2014, China relied on bank credit to finance its private sector to the extent of 142% of GDP, far higher than the ratio of 50% in the US, according to the World Bank. Conversely, China’s stock market capitalization was only 44% of GDP versus 116% in the US in 2012, again on World Bank data.

This reliance on bank credit leads to distortions in the allocation of capital to the most profitable and deserving businesses. Developing domestic stock and bond markets is a key necessity in improving the efficiency of capital. This year’s stock volatility – and another IPO freeze – is a setback in that process.

The government’s actions have also given rise to a version of moral hazard. There is already a persistent belief in the bond markets that the government will rescue troubled companies, leading to mispricing of risk. Last month’s intervention has created a similar belief among equity investors.

Individual investors, who account for a large proportion of equity trading volumes in China, are only likely to have been left with a confused impression of equity as a method of savings.

FOREIGN INVESTORS HAVE also been caught in the maelstrom, with monthly net purchases of mainland stocks under the Shanghai-Hong Kong Stock Connect scheme turning negative in July for the first time since the scheme was launched last November. Investors also found that some of the eligible Chinese stocks had been suspended from trading. In fact, 10 of the SSE 180 index stocks, all of which are eligible for Stock Connect, were still frozen at the time of writing.

In the coming months, we will know if the crash has dented consumer confidence and retail sales, but it is still too early to see the impact on the real economy. For the property sector, on the other hand, the crash may turn out to be a blessing, since savers may turn back to buying property as their preferred saving method. Already, there are mounting signs of stability in the property market, and the stock crash may further help strengthen the sector.

In February this year, US academics published a paper for the National Bureau of Economic Research arguing that “China’s stock market no longer deserves its reputation as a casino”.

The authors measured the ability of market valuations to differentiate between firms that will have high profits in the future from those that will not, concluding that “the informativeness of stock prices about future corporate earnings [in China] has increased steadily, reaching levels that compare favourably with those in the US.”

Had they sought to measure the rationality of the overall market valuation (as opposed to the ability to differentiate between firms), I wonder if they might have reached a rather different conclusion.

This is the reproduction of a recent article in IFR Asia.

Holders of Kaisa’s offshore bonds face an uncertain future after Sunac abandoned its takeover offer for the troubled Chinese­­ property company. While the negotiations rumble on, investors should be paying close attention to the issue of structural subordination in US dollar bonds from Chinese businesses.

In every jurisdiction, whenever a holding company raises debt, it is structurally subordinated to the operating subsidiary’s liabilities. Two of the most important remedies for structural subordination are a guarantee from the operating subsidiary and a charge on the operating company’s assets.

But Chinese holding companies are often incorporated outside China, and when they borrow offshore, the onshore operating companies are not allowed to provide guarantees or pledge their assets as security.

From the early days, nearly 15 years ago, investors have accepted structural subordination in offshore Chinese bonds. Many companies have issued – and have successfully refinanced – offshore bonds. Rating agencies notch down the offshore debt if the onshore debt exceeds a certain level (15%–20% of assets, or 2x Ebitda). And life goes on.

SEVERAL PROBLEMS ARISE from this structure. One issue is that the onshore creditors of the operating subsidiaries get priority in a distressed situation. Onshore debt is often substantial, particularly for Chinese property companies, since they take large construction loans from onshore banks by pledging different properties. That is why several onshore banks have been able to file suits to freeze Kaisa’s assets, while offshore lenders have been left watching powerlessly.

Second, the ability to refinance offshore debt becomes crucial. The offshore issuers are able to pay interest out of dividends from their onshore subsidiaries, but are dependent on refinancing for the repayment of principal, since repatriation of equity funds from onshore subsidiaries requires a lengthy and difficult approval process.

The third problem is that offshore lenders are exposed to subsequent financing decisions, since companies may be able to raise the share of onshore debt in their capital structure and push the offshore lenders deeper into subordination.

Another structure has emerged to allow China-incorporated companies to raise offshore debt without needing the approval of China’s foreign exchange regulator. In this case, the onshore holding company signs a “keepwell” deed, promising to ensure that the offshore SPV that raises the debt will have enough liquidity to service its obligations. It may also sign an equity interest purchase undertaking, promising to purchase some onshore equity interests in order to transfer enough money offshore to pay back the bonds.

However, the robustness of this structure has yet to be tested in practice. Investors’ ability to enforce these agreements is subject to several regulatory approvals from China and hence may fail when the time comes. In any case, claims under these agreements will be subordinated to the onshore company’s secured borrowings.

Last year, China opened a window for onshore companies to provide guarantees or pledge security for offshore debt, but this was subject to a restriction that the funds must be used offshore. Perhaps because of this requirement, there has been a very limited take-up of this structure, even though it is more secure for the offshore investors.

The structural problems assume an added importance when we consider that China has become a much bigger part of Asia’s US dollar bond market. In the closely followed JP Morgan Asia Credit Index, China’s share was in the single digits until 2010, but has soared in the last four years to 34% of all outstanding bonds. In terms of new issues, China’s share used to be 5%–10% between 2005 and 2009, but has since exploded to 55% last year, according to our database. That leaves a large chunk of every investor’s portfolio exposed to the structural subordination issue.

DO WE HAVE any practical means of alleviating these concerns? One useful idea would be to incorporate an offshore reserve account with a portion of the bond proceeds, to cover perhaps six months of interest payments. This would enable a stressed company to continue servicing the bonds without triggering a default, giving an opportunity for potential bidders for the business to emerge. In a situation where competing bidders may raise the recovery value for the bondholders, this period may prove invaluable. We have seen such reserves previously in Indonesian deals: why not bring them to China?

Financial covenants could also be tightened. The terms of offshore bonds usually restrict the amount of onshore debt that can be raised by subsidiaries to 15% of total assets, but the definition of debt often excludes bonds, debentures and other capital-market instruments. This exclusion leaves room for large onshore subsidiaries to raise debt from the onshore bond market, raising the level of subordination for offshore creditors.

Other potential areas for tightening could include the maintenance of a company’s listing status, and the ability to declare default in case the stock is suspended from trading for a prolonged period.

While no lending structure can remedy underlying weakness in the business or corporate-governance failings, investors should not give up on hope of better structures. As long as we are concerned by the structural subordination problems in China, it is time to think about potential solutions, too.

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.