When we published our Asia Credit Outlook for 2019 in March, we anticipated that because of attractive valuations for Asian high yield (HY) bonds, they would offer more opportunities than U.S. and emerging market peers. Yet, after an eventful year, and with the global economy entering a low-growth window of weakness that we expect will persist into 2020, it’s a good time to reassess our outlook.
We’ll publish a fuller analysis of Asian credit prospects at a slightly later stage, but our previous stance still holds: Valuations of Asian HY credits remain attractive. What’s changed, though, are the forces at play in fundamental and technical conditions.
The negative: While China and the U.S. appear to have secured a “phase one” trade deal, the effects of credit stimulus in China are fading. Recent defaults are of concern, while the lack of credit transmission – owing to risk-aversion and capital constraints among weaker banks – is a challenge for policymakers. Despite monetary easing, including deeper cuts in the reserve requirement ratio and a modest decline in official rates, the uptick in bank lending has been milder and slower than after similar measures.
In India, too, the credit transmission mechanism is under pressure despite cuts of 135 basis points (bps) to the headline policy rate by the central bank in 2019. The total flow of financing to the commercial sector fell 881% year-on-year in the first half of FY2020 (i.e., April–September 2019) due to growing risk aversion among non-bank financial companies (NBFCs) following a string of high-profile defaults. NBFCs have been a major driver of credit growth in India, accounting for ca. 20%-252% of incremental loans over the past five years. Sectors most reliant on NBFC funding, including real estate and SMEs, will be hardest hit.
The positives: Despite these trends, corporate fundamentals in Asia3 remain largely intact: Revenues grew 13% year-on-year in 1H2019 compared with 22% in 2H2018; earnings rose 11% in 1H2019 compared with 28% in the second half of last year. However, investors should be aware that there are substantial differences across this universe, with over 500 benchmark issuers across multiple sectors in 17 countries.
And while concerns have risen about defaults in China, we expect the market will remain orderly as weak issuers work out their debt-restructuring situations. We expect the overall Asia offshore default rate in 2020 to be in the benign range (nearer 2% versus 1.1% so far in 2019) with some Chinese industrials and HY local government financing vehicles (LGFVs) being vulnerable.
Technicals - onshore demand remains intact
Supply: We forecast that compared with 2019, gross credit issuance in Asia will be slightly lower in 2020 given less aggressive borrowing from the Chinese property sector, despite property policy having shifted from tight to neutral.
Gross issuance in 2020 will largely come from state-owned enterprises (oil and gas, and chemicals), China property, LGFVs, financials in Hong Kong, South Korea and China, as well as sovereign issuers such as China, Indonesia, Pakistan, and Mongolia.
Demand: Inflows to Asian credit funds have been positive, and onshore demand remains intact, reflecting positive net foreign currency deposit growth. Chinese demand for offshore bonds will continue to depend on the availability of investment quotas, the renminbi-U.S. dollar exchange rate, and the relative yield of offshore and onshore bonds.
Valuations - Asian HY dependent on Chinese credit conditions
Asian HY has outperformed investment grade (IG) credit since Q34, led by Chinese HY property, the outperformance of which was in turn driven by a marginal easing of home-purchase-restriction policies. A rally in the fourth quarter followed strong Golden Week sales in China and a stabilization of onshore data. These facts support the general observation that Asian HY valuations are dependent on Chinese credit conditions. Through 2020 we expect some headwinds due to a high base effect in 1H compared with 1H2019, but this will likely ease towards the second half of the year.
Looking at spreads between Asian credit and comparable securities in other markets, Asian HY remains attractive, with Asian HY having strongly outperformed U.S. HY spreads since Q3. At about 2005 bps, the differential between Asian HY and U.S. HY remains elevated but has compressed somewhat recently.
In aggregate, Asian HY appears cheap, although we highlight that the spread level masks a two-track market, with benchmark names from repeat issuers and preferred sectors trading close to fair value, while bonds from weaker sectors (such as those with low policy support, including Chinese industrials and HY LGFVs), trading at double-digit yields.
Diligent research needed to uncover opportunities
These characteristics mean careful credit selection and active portfolio management will be crucial to managing risks and seeking returns in Asian credit.
A diligent, bottom-up approach is especially important given the mixed outlook, with U.S.-China trade tensions dragging on and weakening growth on the horizon. Broadly, staying in defensive and high-quality sectors within the HY universe, such as infrastructure, renewable energy and gaming, seems prudent, but careful research should also reveal many other opportunities.
1. Source: Citi, Reserve Bank of India
2. Source: Citi, Reserve Bank of India
3. Referring to Asia ex-Japan market; alignment with J.P.Morgan Asia Credit Index (JACI) universe
4. Asian IG represented by ICE BofAML Asian Dollar Investment Grade Index, Asian HY represented by ICE BofAML Asian Dollar High Yield Corporate Index.
5. Source: Bloomberg. Data as of 30 December 2019. Using JACI non-investment grade Z-spread vs Bloomberg Barclays US corporate high yield index OAS.