PORTFOLIO Bonds & fixed income

Look East for strong bond performance

It has been a remarkable past three years for the Asian fixed income market in terms of both investment performance and market growth.

Particularly for the Asian dollar credit market, total return over the period, according to JPMorgan Asian Credit Index (JACI), was 17.49%. At the same time, the Asian local currency market also delivered a respectable 9.31% total return during the same period on a USD-hedged basis, despite the weakening Asian FX trend with only a 2.14% total return in USD terms.

The good performance of Asian bonds was not only due to the more promising economic outlook and improving corporate earnings in Asia, but also because inflows into the emerging markets have been strong, which benefited the region with the higher allocation. As long as market conditions in Asia and the broader emerging markets continue to remain stable, the inflow story is likely to keep the growth momentum going. Meanwhile, the market capitalization of Asian dollar credit market is set to reach its very important USD1trn mark (currently USD744bn) probably within the next two years or so, judging by the rapid pace of new issuances in recent years. Just within the first four month of this year, there has already been USD90bn of new issues priced in the Asian dollar credit market (over 100% more on a year-over-year basis), making it the most impressive start of any year since the inception of Asian bonds as an asset class.

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Asian Credit Fundamental Update
Understanding the ongoing constructive investment flows backdrop definitely helps raise investor confidence in allocating to Asian bonds, but the governing factors of whether they should stay invested should always be based on the views of i) how the Asian economic growth is going to shape up, ii) what the earnings forecasts will be iii) capital spending and leverage trends of Asian corporates.

As we are assessing the fundamental strength of Asian markets, we notice that the slow CAPEX cycle, which began to slow during the global financial crisis, has lowered the gross leverage of Asian corporates and improved their cash levels. The improvement in EBITDA growth and slower debt creation on corporate balance sheets due to reviving business activities and earnings plus recovery of energy prices resulted in better interest coverage and debt servicing capabilities.

To further our study on Asian corporates, the following table summarises some statistics based on the recent Asian corporates’ FY16 results, where we can see that EBITDA growth has been strong whereas net leverage has come down.

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With regards to sector performance, within Asian IG, technology was the outperforming sector while the telecommunications sector was flat. On the Asian high yield side, FY16 results saw real estate and industrials outperforming their peers while telecommunications saw negative growth. Additionally, specifically on Chinese property credits, FY16 results were very strong. EBITDA was up 25% y-on-y, thanks to the strong return of 2015/2016 contracted sales. Debt/EBITDA was flat at 7x y-on-y but it is an improvement from 1H16’s 7.6x. Net gearing also has improved to 71% from 78% y-on-y due to a higher growth in equity. The overall performance from the Chinese property sector has been a pleasant surprise to many investors.

However, credits related to consumer spending in the Asian economies, especially China, remain as our favoured sector, as they continue to shift away from manufacturing-led growth to domestic consumption growth. We also like sectors that will benefit from the growing middle-class population, such as healthcare, nutrition, and leisure. We are also looking for credits with deleveraging potential through earnings growth as overcapacity is being tackled by the government (e.g. steel, cement) via massive scale infrastructure projects (One Belt One Road initiative).

On the Asian economic front, the region is expected to deliver a GDP growth of 6.0% while the inflation forecast remains benign at 2.5%. Disappointments in reflationary policies by the US and current political frictions at the White House have upset the USD bulls and duration bears. While the sensitivity of Asian currencies and Asian rates to USD and US Treasury are likely to stay high, the less confrontational stance between Asia (particularly China) and the US reignites hopes that global growth will not be compromised too much due to unwanted trade frictions. There is also a possibility that Asian economies will continue to reflate (despite the whole reflationary trade idea originating from the US, post Trump elected), thanks to the expected new product launches at the end of this year which will keep the the Asian technology cycle buoyant, benefiting countries such as Korea and Taiwan. With regards to Asian interest rate cycles, it does however appear that the easing bias of Asian central banks is now behind us and if anything, the next rate move in Asia should be a hike. From that perspective, there is little upside left with Asian local rate markets except perhaps Indonesia, if they can successfully convert their recent economic and reform progresses into a rating upgrade (to investment grade) by S&P.

Why invest in Asian fixed income?
Provides diversification: A foray into Asian fixed income affords investors access to a market that is often at a different part of the economic, political and credit cycle to core western markets. This can include economic growth that surpasses most other regions.
Compelling valuations: In an investment world that often seems devoid of income without excess risk, Asian fixed income can offer a compelling proposition in both a relative and absolute sense. Asian fixed income offers asignificant yield pick-up over similarly rated US and European peers.
A dynamic market: Asian fixed income is a dynamic market opening up to a growing number of new investors. This market, which includes both US dollar and local currency issuers, is deep and investible with a market capitalisation of around US$1.4 trillion and an asset class that has grown more than four fold in the last six years.

Conclusion
The backdrop for global fixed income will be challenged by signs of reflation including more stimulative fiscal policy in the US and more resilient energy and commodity markets worldwide, despite some recent setbacks. However, we haven’t seen a synchronized growth across global regions for a long while and there are signs showing it is probably underway which should be encouraging for risk assets to sustain their rallying.

Meanwhile, the broad financial market is currently trading in an environment with its asset values priced precisely to perfection which leaves no room for cushioning any market shocks. Both the cyclical and structural changes to our global economies (technology-led disruptions) and demographics (aging population) are going to lead different segments of our asset classes in very different directions, unseating our conventional thinking about market correlation, mean reversion, implied volatility, and portfolio construction (public or private, active or passive, equities or fixed income, mainstream or bespoke).

Regardless, we believe that there are still interesting themes to be investigated across Asian fixed income markets. These are to be found, for example, in dynamic industry sectors such as Chinese e-commerce, technology, healthcare, or the accommodative yet less-intervening stance on interest rates and currencies of Asian central banks.

A flexible, active approach will continue to allow investors to benefit from these themes and from Asia’s diverse array of growth. We believe the style of our active management will also add value and help our investors to navigate the ups and downs of market volatility.


Clifford Lau, CFA - Head of Fixed Income, Asia - Columbia Threadneedle Investments

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