Weathering through the storm with Asian high yield bonds

The spread of the Covid-19 globally, coupled with the plunge in oil prices, has created a maelstrom in the global financial markets in March. Market volatility surged, while global equities fell to multi-year lows. US Treasuries were not spared the volatility. On the back of an aggressive 150 basis points (bps) rate cut by the Federal Reserve in March alone, 10-year US Treasury yields fell to a record low of 0.3% before surging to 1.2% on the back of a USD liquidity squeeze as investors clamoured for cash.

Against this backdrop, Asian hard currency bonds, particularly Asian high yield bonds, experienced steep declines. Month-to-date, Asian high yield bonds fell by 12%¹, while Asian investment grade bonds fell by 4%². The decline in the high yield bond market was led by the higher-beta segments of the market, such as Indonesian corporate credits. Commodity-related credits also took a hit, impacted by the collapse in oil prices and concerns over waning oil demand amid the global slowdown.

We note that the recent price action in the Asian bond market has been unusually swift. During the Global Financial Crisis (GFC), it took around 15 months for Asian high yield corporate credit spreads to widen from its tightest to reach above 900 bps. Meanwhile, it took 8 months for credit spreads to reach similar levels during the European Sovereign Debt crisis. In the current sell-off, it took only around 2 months for Asian high yield corporate credit spreads to rise above 900 bps from trough to peak. Asian high yield bonds currently offer an average yield of nearly 10%³. While the prevailing market conditions have been exceptional and the challenges unprecedented, the speed of the current sell-off raises the question of whether the correction has been too fast and too extreme. At the same time, while credit spreads of Asian high yield corporate bonds have not reached the highs seen at the peak of the Global Financial Crisis, they are at decade highs. The last time credit spreads reached these levels was during the European Sovereign Debt crisis. See Fig. 1.

Fig. 1. JACI High Yield Corporate spreads (basis points)⁴

At current spreads, Asian high yield corporate credits are already pricing in more than a 10% default rate (assuming 20% recovery rate). See Fig. 2. This appears to be excessive given that during the depths of the GFC, the calendar year high yield default rate in Asia was only around 9%.

Fig. 2. JACI High Yield Corporate Spread – Implied annual default rate⁵

Short-term volatility notwithstanding, we believe that valuations of Asian high yield bonds have reached attractive levels from a historical perspective, especially for investors with a medium-to-long-term horizon. Since end September 2005, investors who have entered the market at spread levels of above 800 bps, would have enjoyed an average annualised total return of 16% on a rolling 3-year basis⁶.

Furthermore, we believe that there are important differences which sets the current market situation apart from the GFC. These differences suggest that the spreads of Asian high yield bonds are unlikely to revisit the levels last seen at the peak of the GFC.

The change in investor profile is one key factor. Before 2008, Asian investors accounted for less than 50% of Asian bond allocation. Today, allocation to Asian investors represents more than 70% of the new issuances. See Fig. 3. We believe that a large Asian investor base potentially reduces selling pressure from cross-over funds or speculative investors outside of Asia, who may be quicker to sell down non-benchmark investments in their portfolios. Asian investors’ familiarity to the region and to the bond issuers should also help to mitigate risks of indiscriminate selling at the first sign of market weakness.

Fig. 3. Asian credit is now around 80% owned by Asia-based credit investors⁷

On the macroeconomic front, while we acknowledge that there is still much uncertainty with regard to the length and severity of the Covid-19 outbreak, there are also notable differences from the GFC. The GFC was a sudden systemic shock that was triggered by a breakdown in the financial system which had spillover effects onto the real economy. Today, global banks are less leveraged and much better regulated. The current sharp slowdown in global economic activity, caused by the mandatory and self-enforced containment measures, would hurt corporate and household incomes. The amount of stress on corporates and households, as well as the shape of the recovery, would depend on how the virus situation unfolds.

We remain hopeful that the economic impact of the virus is only temporary and there could be a potential rebound once we see signs that the outbreak is being contained in major economies. Around the world, governments have rolled out unprecedented policy measures to combat the economic impact of the outbreak; these would help many companies ride through the short-term challenges. In the US, a USD2 tr Phase 3 fiscal package was recently announced; providing direct cash transfers to households, as well as rolling out a lending program and government guaranteed loans to companies. The Federal Reserve has also launched a raft of measures aimed at lowering borrowing costs and providing liquidity to the market. In Asia, policy rates have been cut in a hurry, some to record lows, while unprecedented fiscal measures have also been rolled out.

China’s experience in dealing with the virus also gives us hope that the setback to growth, while steep at its peak, could be transitory if the outbreak can be effectively contained. We are currently seeing economic activities gradually resume in China. Power consumption has increased and property sales as well as construction activities have resumed.

While it is debatable whether investor sentiment has bottomed, history shows that it is possible for Asian credits to lead the recovery ahead of the equity market, as was the case during the GFC. Fig. 4 shows that the Asian high yield credit market, led the equity market by a good 3 months. The S&P 500 bottomed in March 2009 while Asian high yield corporate bonds bottomed much earlier, in November 2008.

Fig. 4. S&P 500 versus JACI High Yield corporate index⁸

Other than the Covid-19 impact, investors have been concerned about the sharp falls in oil prices following Saudi Arabia’s decision to increase oil output. Investor concerns, however, may be excessive on this front. Oil and gas credits make up less than 2% of the total Asian USD high yield credit market⁹, significantly lower than the 12% exposure in the US high yield benchmark¹⁰. The direct impact of the fall in oil prices on the overall Asian high yield bond market is thus expected to be manageable.

On a macroeconomic front, Asia also typically benefits from lower oil prices as many countries are net energy importers. See Fig. 5. While this round of lower oil prices may not lift discretionary spending like it did in the past given the numerous lockdowns on social activities, a lower oil import bill can still boost state coffers, giving some governments the fiscal ammunition they need to blunt the economic impact of the outbreak.

Fig. 5. GDP impact (%) from fall in Brent crude from USD60/bbl to USD35/bbl¹¹

We expect volatility to remain elevated in the near-term as weak investor sentiment, growth concerns and selling pressure from leveraged investors who are covering their margin calls to all weigh on the Asian high yield bond market. The slowdown in global growth is also likely to trigger a spate of rating downgrades. Weaker issuers with imminent debt maturities could face funding pressures.

In this environment, we believe that the close monitoring of our issuers in terms of their earnings outlook and access to liquidity, as well as stress-testing these assumptions, would be important. However, we expect the overall market default risks to remain manageable for the year, with a moderate increase in the default rate from initial market expectations of 2-3%. Default risks are partly mitigated by the supportive policy measures highlighted above, as well as by the manageable financing needs for most of the issuers under our coverage.

Importantly, for long-term investors, the current indiscriminate sell-off presents attractive entry points, especially in issuers which we believe have the wherewithal to ride out the current challenges. We will thus be inclined to increase portfolio beta, while selectively adding to credits which we view to be oversold. For example, We have been progressively adding to our overweight exposure in the China high yield real estate sector, where we remain comfortable with the sector’s fundamental outlook. As mentioned above, signs of a pickup in property sales and construction activities in China have emerged amid a stabilisation in the virus situation and supportive policy measures. The larger and higher quality developers are reporting improving weekly housing sales figures. We also do not see imminent refinancing risks in the sector as issuers have largely pre-funded their refinancing needs up to at least the third quarter of this year. Meanwhile onshore funding access to credit has also eased.