Asset allocators face a tricky decision. Should they continue pumping funds into Asian high yield, where momentum remains strong but credit spreads are at historically tight levels and potentially at risk of a blow out?
In 2016, high-yield bonds were one of the world’s best-performing asset classes, particularly US issues, which benefited from a weak base effect in 2015. The Bank of America Merrill Lynch US High Yield Index rose 17.5% over the course of the year after dropping 4.7% the previous year thanks to a blowout in energy-related bonds.
Asia, by contrast, has been consistently strong in recent years. In 2016, the region’s high-yield sector returned 11.2% according to the JACI High Yield Index and 2017 has continued the trend.
Year-to-date, the JACI High Index is up 3.1% to Thursday’s close compared to 3.19% for the BofA ML US High Yield Index and 2.74% for JP Morgan’s Corporate Emerging Markets Bond Index (CEMBI).
However, Jim Veneau, head of Asian fixed income at Axa Investment Managers, believes the market is reaching an inflexion point, with the lowest-rated credits at risk of blowing out by up to 300bp based on historical averages.
“If you’re an asset allocator, this is a very challenging environment,” he told AsianInvestor. “High-yield spreads have compressed to very tight levels, and the question is: where do markets go from here?”
Veneau said single B-rated Asian corporate spreads are averaging 350bp on a Z-spread basis; the same level that many BBB-rated Asian corporates were trading at a couple of years ago.
(The Z, or zero-volatility spread uses the zero-coupon yield curve to calculate the spread. The Z-spread is the number of basis points that would have to be added to the spot yield curve so that the bond’s discounted cash flows equal the bond’s present value.)
Whither the Asian premium?
Veneau also argues that Asian spreads are expensive relative to US high-yield comparables. Prior to the energy-driven US high-yield meltdown, Asian single-B credits were trading at roughly a 300bp premium to US single-B credits.
China’s heavy weighting in the Asian high-yield universe accounts for the theoretical need for an Asian premium, since the country’s offshore bond issues have a structurally subordinate ranking within a company’s capital structure.
The Asian premium for single-B credits is about 50bp to 70bp, said Sean Chang head of Asian debt investment at Baring Asset Management. But he believes Asian high yield is not yet overvalued against US comparables, or on a stand-alone basis.
“We think the Asian premium will continue to contract,” he commented. “Earnings are good and the region is still a strong growth engine for the world economy.”
Both Chang and Veneau agreed that market momentum had been very strong and could push spreads tighter yet. This is largely because Chinese private banks and institutions are the biggest regional buyers and continue to move money offshore into dollar-denominated bonds as the renminbi is forecast to weaken.
FinanceAsia, a sister publication to AsianInvestor, has been reporting how Asian high-yield bonds are attracting big order books.
For example, Chinese toll road company, Road King, drew $5.5 billion in demand for a $300 million perpetual bond deal on February 13 even though the B1/BB- rated issuer dispensed with an investor-friendly step-up mechanism. And the deal has continued to perform well in the secondary market, rising two-and-a-half points to a mid-price of 102.625% as of Thursday’s close.
And this momentum can continue, according to research conducted by JP Morgan’s emerging markets strategy team between February 20 and 22.
Their straw poll of EM investors managing $1.1 trillion in assets determined that only 18% believe there will be a correction in CEMBI spreads. The poll also found that cash holdings are coming down, falling 0.1 percentage points month-on-month to 4.1%.
Axa IM’s Veneau adds that net issuance in the Chinese property sector – which dominates mainland issuance – could be flat to slightly negative in 2017 because of high redemption levels, which should underpin spreads.
Spread compression at the long end?
He also believes there is still potential for spread compression at the longer end of the maturity curve. “It’s the only remaining frontier for spread compression, because some curves are steep,” Veneau commented.
However, moving down the curve exposes investors to magnified duration risk, given that the market believes US interest rates will rise.
“It’s possible to hedge against interest rate risk by selling US Treasury futures,” Veneau noted. “But 30-year Treasuries are less liquid than 10-year Treasuries, and there’s additional basis risk, so it’s possible but more technically challenging.”
He suggests investors avoid duration risk and go for a neutral or short strategy. Barings’ Chang also flags the risk of rising interest rates.
“This is my main caveat, as the likelihood of a rate hike in March is increasing,” Chang commented. “Just before the last hike in December, investors de-leveraged or liquidated some of their positions, driving up Asian yields relative to their US counterparts.”
Veneau concludes that Asian high yield has done very well but that total-return opportunities would soon disappear. “It’s time to go for defensive carry positioning,” he argued.
A carry strategy should still deliver positive returns and is the main reason portfolio managers believe asset allocators should stay invested in Asian high yield. But they caution investors to be conscious about what they are exposed to.
This is not because portfolio managers believe defaults will rise over the coming year – Veneau thinks they are likely to be lower than normal – but because of rising geopolitical risks.
“It’s not so much about owning a credit, but understanding how global macro events could affect it, since this is where the main risks lie,” Veneau concluded. “When spreads are this tight, it only takes the smallest whisper for them to widen sharply.”