Valuations and outlook of Asian credit remain attractive
The prospect of US rate hikes along with the recent sell-off in US and European sovereign bonds has caught investors’ attention and raised concerns over the outlook for US dollar denominated Asian credit. While rising yields in the US remain a key risk to Asian bonds, our outlook for Asian credit remains constructive given a friendly mix of moderating global growth and broadly accommodative global central bank policies.
Higher yields in Asian USD bonds vs those of developed markets can provide investors with a decent buffer against any US interest rate hikes. In addition, as rising rates are usually linked to improvements in the economic environment, credit spreads are historically negatively correlated to rate hikes. We believe there is further room for spread compression in this market, especially in Asian high yield.
In terms of value, relative valuations of Asian credit are also attractive, especially when economic growth within the region has remained resilient when compared to other regions. The credit default rate for Asian high yield has been low (1.4% in 2014 and 1.0% in 2013). Though we expect a modest increase in the default rate this year, we expect it to remain significantly below the rest of the world due to manageable refinancing risk.
While the macro and credit outlook for Asian bonds looks healthy, they also offer decent spreads over peers in the US and Europe. For instance, Asian high-yield bonds offer 531 bps spreads over government bonds, while European high-yield bonds offer only 386 bps (Merrill Lynch Indices as of May 31, 2015). This, coupled with the healthy fundamentals of Asia, have led us to remain constructive about the outlook for this asset class.
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Favourable technical factors also support our positive view on Asian credit. Net issuance is expected to be low, while investor demand continues to be robust, with a notable increase in local investor bids for Chinese bonds. Big steps taken by the Chinese government in the interest rate liberalisation process and the gradual opening up of the Chinese capital markets should help support near-term confidence and lift investors’ sentiment towards Chinese bonds.
Asian local currency bonds to benefit from accommodative policy
Accommodative monetary policy in Asia, with further easing expected in some countries, will likely support the performance of local currency bond markets in Asia. In general, we continue to see moderating growth, soft domestic demand and subdued inflation in the region, which tends to favour the Asian local currency bond markets. The outlook is particularly positive because Asia has been the biggest beneficiary of lower oil prices since late 2014 (with Malaysia being the exception). However, given the divergent characteristics of each country, it’s important not to take a pan-Asia view under the current market environment.
As mentioned, most Asian central banks will likely maintain an accommodative monetary policy stance. Several Asian countries continue to provide decent real rates, which is positive for bond markets, as it gives room for central banks to cut interest rates. China, India and Thailand are the key countries we are positive on at the moment, while we are underweight in Singapore, due to its high correlation to US rates.
Asian currencies have held up well in the past year, despite US dollar strength. Yet, very quietly, the US dollar rally has stalled. Since the middle of March, USD exchange rates against other major currencies have stabilised somewhat but the overwhelming consensus still argues for a stronger dollar. This perfectly reasonable hypothesis is based on the fact that the US is growing more quickly than Europe and Japan, and will soon adopt tighter monetary policy.
There is no escaping the fact that Asian currencies are correlated to other non-dollar currencies, and if the US dollar rallies, this strategy is unlikely to be popular among global investors for that reason. Nevertheless, the market still posted a decent positive return in 2014 in USD terms and a very good return against most other major currencies. If the US dollar strength abates, however, this could be good news indeed for investors in Asian local currency bonds. Not only do Asian bonds provide better yield carry than their global counterparts, but with Asian economies generally performing better than other parts of the world, currency returns could boost the overall performance into attractive territory over the long term.
Moreover, in a world where everyone is looking for the turning point in the bond rally and US interest rates, Asian local currencies provide a good diversification away from the binary gamble between the euro and the dollar and an opportunity to enhance the yield of a broader portfolio. The turning point may not be just yet, but it may be closer than the view of the consensus.
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