Extraordinary monetary policy, uncertain economic growth, demographic shifts, and fiscal imbalances have kept interest rates near all-time lows. However, today’s fixed-income landscape is more challenging than just a low-yield environment; it’s not hyperbole to say that investors are facing some of the least attractive rates in modern times.
Generating attractive income is no longer just a matter of moving farther out on the yield curve or down the credit quality spectrum. Recent volatility triggered by elevated interest rates has made it difficult to not only find yield, but also to achieve price returns and portfolio diversification.
In the current environment, investors should consider incorporating other segments (and other risks) of the fixed-income universe in pursuit of higher returns.
In the second quarter of 2021, Asia high-yield bonds have been relatively sheltered from the steep rise in yields seen in the first quarter. This is particularly true for the Asian high-yield asset class that has a significantly shorter duration than global investment grade and comparable high-yield markets. The attractiveness risk reward of Asia high yield is clear – the amount of yield pickup on Asia high yield over comparable US and European high yield are near all-time wides and Asia high yield provides almost twice the amount of yield in US high yield with half the expected default rate.
Diversification of Asia fixed income is another key feature. Chinese government bonds continue to have a low correlation to US rates, through the period right after March 2020 when Chinese government bond rates rose before US rates and were pretty much stable this year and insulated from the rise in US government rates so far this year.
This was largely because China monetary policy was running at a different point of the cycle compared to the rest of the developed world. Earlier in March, Chinese property names came under stress in view of monetary policy tightening concerns in China and underperformed the non-China issuers in Asia high yield, which were more exposed to the cyclical sectors such as commodities.
We expect the Chinese property market to be relatively stable – supported by robust housing demand offset by tighter credit conditions that, in the long run, would ensure sustainability in the sector. The measures intended to control property developer debt levels, commonly known as the “three red lines”, would lead to increasing divergence among developers, depending on who would be able to access financing effectively. Active management in the form of credit selection and research would be key to avoid idiosyncratic risks and pick the winners in the property industry undergoing consolidation.
We have also seen similar themes of credit tightening in onshore markets as policy has reverted to deleveraging and focusing on financial risks. With the market recognizing the government’s stance of gradually reducing support for non-strategic state-owned enterprises (SOEs) and local government financing vehicles (LGFVs), we have seen a rise in onshore defaults, including in SOEs. However, we are seeing onshore SOE and LGFV bond supply increase to meet credit needs to ease the pressure while that from privately owned enterprises (POEs) continues to fall. Large SOE banks that are responsible for a significant part of the credit system are exposed to SOEs rather than the POEs. Overall onshore default rates remain relatively low compared to the global markets and, with the market mostly held by onshore investors, the rise in defaults is unlikely to cause significant systemic risks within China or outside of China.
Within emerging markets, we focus on the stronger fiscal stories that we believe would be more defensive in an environment of higher rates and funding costs. This would point to MENA investment grade sovereigns such as United Arab Emirates and Saudi Arabia, which will benefit from higher commodity prices and in turn move towards fiscal consolidation. In Asia, we prefer Indonesia over the Philippines where we see some risks of fiscal deterioration. Further down the credit curve, we are looking at Indonesia with quasis such as Pertamina, which also benefits from higher oil prices.
Asia FX has so far lagged the rebound in reflation assets. This is likely due to concerns over the rise in Covid-19 cases across parts of the region. In India, we saw daily virus cases surge past last year’s highs and reach a peak of almost 400,000 daily cases before coming off. However, the authorities’ response to the second wave has been to resist a nationwide lockdown and focus the lockdown and restrictions at a local level, thus helping the economy from contracting materially. The growth impact has not been insignificant as we saw mobility measures coming off sharply – some of which were worse than last year. The expectations of markets and the rating agencies are that the growth and fiscal impact from this second wave would not scar the recovery but the current market valuations such as in India credits or the Indian rupee have so far priced in little fallen angel risk.
Howe Chung Wan is managing director, head of Asian fixed income, at Principal Global Investors.