For investors escaping negative yields, the Asian bond market offers refuge with higher yields and stable returns. But to make the most out of this opportunity, investors have to navigate idiosyncratic risks and the impact of policy and politics, as seen in the recent Chinese yuan movement and the uncertain trajectory of the US-China trade negotiations.

A STABLE MARKET MAKES ASIAN BONDS MORE ATTRACTIVE

Arthur Lau, CFA, co-head
of emerging markets fixed
income and head of Asia
ex-Japan fixed income

Asian bonds saw strong inflows in the first half of 2019. While Asian bonds are still underrepresented in global benchmarks, investors increasingly recognise their diversification benefits. Contrary to misconception, the Asian bond market is not a high-yield market with high beta and volatility.

Over the past five years, Asian bonds’ Sharpe ratio (i.e., the volatility-adjusted return ratio) has held up very well at 1.59 compared with those of other major asset classes globally (US investment

grade credit: 0.99, emerging markets US dollar: 0.94, and US equities: 0.88).1 One reason for this is the strong domestic investor base that understands Asia’s bond market.

Asian bond issuers also tend to have very low gearing ratios (corporate net leverage) and high interest coverage ratios compared with their peers in the emerging markets and even some of the developed markets. This is another reason why the Asian market has been able to deliver such a high Sharpe ratio over different business cycles, including some major macro events in the past five years.

Since the 1997 Asian financial crisis, there have been no defaults in the Asian investment grade bond universe. Aside from high credit quality, high systematic government support for some issuers, especially state-owned enterprises, contributes to the market’s stability. So when market volatility exists, we think the Asian bond market actually becomes more attractive to long-term institutional investors.

TRADE UNCERTAINTY AND MONETARY POLICY PIVOTS
Two themes figured prominently in the Asian bond market this year: shifts in monetary policy and the US-China trade dispute.

The pivot toward easing by the US Federal Reserve and some Asian central banks provided a positive backdrop for Asian bonds. With developed market bonds offering negative to negligible yields, higher-yielding Asian bonds become harder to ignore.

On the other hand, given the uncertainty around the trade dispute between the US and China, we expect the Asian bond and currency markets to remain choppy in the near term. As an anchor currency in the global market, the recent move in the Chinese currency past 7 against the US dollar and the US designation of China as a currency manipulator will likely intensify the volatility in the currency market in the region and trigger more risk aversion. However, the majority of Asian bond issuers are mainly domestically focus, or with revenue largely sourced in US dollars. As such, we do not believe higher volatility in the yuan will cause a large scale credit deterioration in the Asia bond markets.

The trajectory of the yuan will highly hinge on the development of the trade negotiations. Additional and further negative developments in the trade talk with the US means China is less likely to hold a conciliatory stance on the currency given greater pressure to mitigate the tariffs negative impact on exports.

Over the long term, we expect the Asian bond market should remain resilient and attractive. On an index level, less than 3% of Asian bonds are directly affected by the tariffs, and the tariff impact is not linear. Some companies may absorb the cost of tariffs through margin compression. While an unfavorable outcome to the dispute could hurt economies like Korea, Japan, and Taiwan, it could benefit others as production shifts from China to Southeast Asia, for example.

Active management offers the flexibility to navigate across the risk spectrum and take a more selective approach.

CAPTURING EMERGING OPPORTUNITIES IN A COMPLEX WORLD
In the diverse Asian bond market, the key is to be more tactical in allocating across sectors, countries, and names. A holistic view of economic and political developments, along with rigorous credit analysis, will become even more critical.

The Chinese property sector, for example, offers select opportunities within a fragmented market. Defaults have risen recently on the back of the nationwide deleveraging effort, and we expect weaker and marginal developers to continue to face challenges. Yet, this is unlikely to become systemic, in our view, and we expect the sector’s overall credit quality to improve over time.

Meanwhile, a new rule prescribes that Chinese property companies can only issue US dollar bonds for refinancing offshore long-term debt maturing within one year. This has both positive and potentially negative implications. The rule essentially sets a cap on the total amount of offshore long-term debt, which should provide supportive technical drivers for Chinese property bonds. But it could also potentially create funding and liquidity pressures for companies with weaker credit profiles or those that have limited access to multiple funding sources.

Another example is Indian regulators’ recent larger-than-expected capital injection plan for the banking sector. We believe the plan should help public sector banks and, in general, the broader banking system in dealing with asset quality and liquidity issues. This should present potential investment opportunities in this sector, but only if the plan is effectively implemented.

These developments underscore how value can be highly dispersed in Asian bonds, making credit selection especially important. If you can identify those stronger players, you can find opportunities.

1. Bloomberg, rolling five-year data as of 30 June 2019. Asia US dollar bonds by the JPM JACI index; emerging markets (US dollar) by the JPM EMBI Global Diversified index; US investment grade credit by the Bloomberg Barclays US Credit index; and US equities by the S&P 500 index.
 

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Last updated 22 July 2019