A difficult year for Asian high yield so far

2018 to date has not been a good year for Asian high yield (non-investment grade) bonds.

The JPMorgan Asia Credit Index “JACI” non-investment grade sub-index has declined 2.7% year-to-date as at 31 July 2018. The index has underperformed the JACI investment grade sub-index, which was only down 1.5% (see Fig. 1).

Returns of Asian high yield have been driven primarily by credit spread widening, where spreads in the high yield segment have widened by 103 bps year-to-date (see Fig.2).

From their tightest levels in recent times (end-March 2017), spreads have widened 159 bps (after widening by as much as 239 bps in mid-July).

In the context of prior spread widening occurrences, this is worse than the 2013 “Taper Tantrum” experience, and is of a similar magnitude to the period in 2015 which was characterised by immense volatility in China’s financial market (see Fig.3).

Reasons for the wintery pall over Asian high yield bonds

While 2018 has been fraught with geopolitical tensions emanating from the Sino-US trade spat, a confluence of other factors has cast a pall on the Asian high yield bond market.

Higher risk-free rates

The rise in risk free rates (the 5-year US Treasury yield has gained 62 bps year-to-date, as at 31 July 2018) has resulted in a rapid repricing of Asian USD-denominated bonds. While the shorter duration nature of much of the Asian high yield bonds has been a mitigating factor, higher rates still had a negative impact on year-to-date Asian high yield bond returns.

Higher cost of funding for leveraged investors

In conjunction with the ongoing Federal Reserve rate hikes and the corresponding rise in risk-free rates, the cost of LIBOR (London Inter-Bank Offered Rate) funding has increased, sapping demand from leveraged investors in Asian credit.

As shown in Fig.4, the 3-month LIBOR has risen 200 bps from 30 October 2015 to 24 July 2018 – given the low base of rates, this represents a near 600% increase.

Weakening “China bid”, LGFV woes, credit default concerns

With an increased focus on debt management, China’s deleveraging push has diminished the influence of wealth management products, hurting demand for China high yield bonds, corporate perpetuals and China bank Additional Tier 1 securities (AT1s).

Coupled with the increased scrutiny on China onshore defaults as well as concerns over Local Government Financing Vehicles (LGFVs), this has created a near-perfect storm for China high yield bonds.

China’s non-investment grade bonds registered an average -3.6% year-to-date return⁵, underperforming other countries within the Asian high yield universe. Adding further fuel to the mix, there were a number of credit defaults in the offshore bond market, driving up the full-year anticipated default rate for Asian high yield bonds.

New issuance has slowed considerably

Symptomatic of weak investor appetite for Asian high yield bonds, there has been a notable slowdown in new issuance, particularly in June 2018 (see Fig.5). Anecdotally, we have observed selected issuers failing to print bonds after the announcement of a new issue.

Signs that “winter” is ending

While it may be too early to call an end to the “winter” for Asian high yield, there are some signs of rejuvenation.

Stabilising investor flows

For a start, investor outflows are starting to look a bit fatigued. As a proxy, Emerging Market retail bond fund flows have finally turned positive after 4 July 2018, following six consecutive weeks of outflows.

Fund flows have turned positive for three consecutive weeks⁷ since then. While the flows are not large, it appears that investors are warming up to the beleaguered markets in Asia and the Emerging Markets.

Improved valuations

Investor flows may have been attracted to the significantly improved valuations in Asian credit markets. Asian high yield corporate spreads have widened by as much as 239 bps since their recent nadir in March 2017, while yields are amongst the highest over the past six years (see Fig.6).

As a gauge of relative value against their US high yield counterparts, B-rated Asian high yield bonds currently trade at spread premiums of 192 bps, as at 1 August 2018 (see Fig.7).

China policy turning more supportive

While tightening financial market conditions onshore have made the operating environment more difficult for China companies, there are signs that the government is prepared to ease monetary and fiscal policy to bolster the economy. Perhaps, it is in recognition that ongoing deleveraging efforts are having a negative impact on economic conditions and access to financing.

In addition to the reserve requirement ratio (RRR) cuts in 2018, the People’s Bank of China has also injected funds via its medium-term lending facility (MLF) to improve liquidity. It has also utilised “window guidance” to encourage more lending by onshore banks, alongside an easing of loan quotas.

From the State Council Meeting held in late July, the message was for more proactive fiscal easing, including a tax cut, focusing on small and medium enterprises. Plans were laid for the impending issuance of 1.35 trillion yuan of special bonds for local governments pertaining to ongoing infrastructure projects.

In addition, the State Council also guided for financial institutions to ensure that LGFVs will have access to financing, in order not to hold up construction and planning of public projects. While not a direct form of support for the beleaguered segment, it represents a departure from prior government language, which consisted of a tightening of LGFV borrowing ability, and stricter underwriting standards, as well as a dissociation of implied government support.

Default risk appears contained

With higher profile idiosyncratic defaults/restructuring events already seen in selected segments earlier this year, investor expectations for Asian high yield defaults have risen.

We note that selected rating agency and “sell-side” forecasts for 2018 full-year Asian high yield defaults have risen from approximately 1.9%¹⁰ at the start of the year to around 2.8%¹¹ presently, which is still manageable.

More recent forecasts also have the benefit of taking into account prevailing weak/distressed pricing on selected bonds which could potentially be default candidates

While historical default rates have been higher, the increasing breadth of issuers (442 issues from 259 issuers in the JACI non-investment grade sub-index, as at 31 July 2018) and sheer size of the market (USD202 billion in market value) means it will be a tall order for default rates to trend back to historical peaks.

A “thawing” primary market

Following an extremely quiet period for Asian high yield issuance in June 2018, the primary market appears to be thawing, with USD2.6 billion¹² of Asian G3 high yield corporate bonds launched in July 2018. This represents a doubling of new issuance, compared to the USD1.3 billion, seen in June 2018.

The ability for lower-quality issuers to tap debt capital markets is a positive for issuer liquidity; reinvigorated book-building activity could alleviate concerns of a credit crunch, and allow investors to focus more on fundamentals again.

Fundamentals remain healthy

As opposed to what weak market technicals suggest, Asia credit fundamentals remain healthy – Asian high yield credit ratings were actually on a trend of aggregate improvement in 1Q 18, with more upgrades than downgrades seen¹³.

This has come on the back of a strong global growth backdrop, with the US economy recently registering a better-than-expected 4.1% annualised pace of growth in 2Q 18 versus the first quarter¹⁴. While trade tensions may weigh on business confidence and growth in selected markets, we see pockets of strength in specific sectors.

Highlighting the strong corporate fundamentals for Asian corporates, China real estate developers (which constitute 31% of the Asian high yield market) continue to report strong operational performance.

27 major China property companies registered a sizeable 35% year-on-year growth in year-to-date contracted sales at the end of June 2018, with only two companies registering a year-on-year contraction in sales for the period. This strong trend in contracted sales is a positive for future profitability and debt-servicing activity for the sector.

Too early to call an end to “winter”, but green shoots are visible

It is perhaps premature to call an end to the current difficult period for Asian high yield bonds, but there are indications that the market is on a path of revival, with stabilisation on the technical front (fund flows) accompanied by positive policy tweaks and still-healthy corporate fundamentals.

With the significant widening in Asian high yield credit spreads and the sharp rise in yields, the risk-reward trade-off appears to have swung towards risk-taking at this juncture, even as market volatility is likely to continue.

At this juncture, we see pockets of opportunity in selected China property bonds as well as in specific credits in the Indonesia commodity sector. Conversely, we are less positive on Indonesian property and will remain highly selective in that segment.

We are also seeing less value in Indian high yield credits, where technicals have been more supportive on weak supply. The investor exodus from Emerging Markets has also brought about opportunities in local currency bonds, where Indonesian Rupiah and Indian Rupee local bonds offer higher-carry, yield-enhancement opportunities.