Asia BB credit is the sweet spot
One for the record books. 2019 would be remembered as the year that rationality in the bond markets seemingly evaporated, as investors witnessed the global supply of negative yielding Investment Grade (IG) debt surge to a peak of USD17t in the third quarter. At that point, nearly a third of all outstanding IG bonds guaranteed a loss to buyers if held to maturity. Credit spreads followed suit with broad-based narrowing across both IG and High Yield (HY) bonds, spurred by the dovish tilt of central banks around the world toward their respective one-year tights.
The challenge for the year, or perhaps even the decade ahead, is to justify staying invested in what some may consider to be one of the most overvalued asset classes in the world today.
Figure 1: Global bond returns have eclipsed their respective five-year averages in 2019
Source: Bloomberg, DBS
No risk, no returns. One might consider cashing out following a year of remarkable gains, but holding cash in a world of zero or even negative rates unfortunately means that the risk-free asset is simultaneously return-free. The concept of “TINA”, or “There Is No Alternative”, is also at play here; investors have no choice but to look for yields by expanding their appetite for credit risk. Although one should not get carried away chasing every high-carry asset the market has to offer, there are still several valid reasons for value-hunters to stay invested in bonds.
A credit picker’s market -- the case for selectively taking credit risk exposure. US economic growth is presently in a “goldilocks” scenario for credit to perform decently – not too slow as to induce widespread concern of systemic defaults, while also not too fast as to spur central banks to aggressively hike rates and tighten financial conditions.
Figure 2: Credit spread sensitivity to rate of change in q/q GDP growth (since 2003)
Source: Bloomberg, DBS
As shown in Figure 2, credit spreads exhibit a track record of tightening when growth expectations are modest, with a magnitude inversely proportional to credit quality. In other words, investors were rewarded for taking additional credit risk in a stable growth environment. As the global credit markets have exhibited high sensitivity to US data, we believe that this supportive environment has similar implications for broader Emerging Markets (EM) credit as well. Moreover, the dovish inclination of Developed Markets’ (DM) central banks, along with uncertainty around the US elections, lends to the attractiveness of EM debt from a macro perspective – support is found with the flow picture observed in the first few weeks of 2020 (Figure 3).
Figure 3: Strong EM hard currency fund flows at the turn of the year
Source: Bloomberg, DBS
These factors lend credence to investors looking to chase yields by going down the credit quality spectrum. In terms of relative valuations, spread ratios of HY vs IG credits (where we divide the credit spread of HY bonds by the spread of IG bonds) are not stretched at this juncture, despite the strong performance in HY credits at the turn of the year. Most ratios still lie above their long-term averages (Figure 4).
Figure 4: HY/IG spread ratios against their respective long-term averages
Source: Bloomberg, DBS
In particular, the Asia HY/IG spread ratio looks interesting given the larger deviation from its long-term average, possibly exacerbated over the last two years by the rising US-China trade tensions – seeing as the Asia HY/IG ratio (blue line) has trended above the US HY/IG ratio (light grey line) in that same period.
With valuations seemingly undemanding, we then consider what the range of returns of Asia HY might look like for 2020 by plotting one-year forward total returns (y-axis) against initial spreads (x-axis) for Asia HY, using weekly data in the last 10 years (Figure 5).
Figure 5: Asia HY Spreads starting relatively high – raises the odds of positive total returns
Source: Bloomberg, DBS
Intuitively, the positive correlation simply means that the wider spreads are at entry, the better the odds of positive returns. Notice that the majority of data points show positive total returns for Asia HY on a one-year forward basis; episodes of losses only occurred when Asia HY initial spreads were less than 473bps. For 2020, the Asia HY initial spread is 535bps. Based on historical trends, total returns from this reference point have ranged between 3% and 20%, which again supports the outlook for Asia HY in general.
That said, one would be hard pressed to expect the same double-digit returns for HY seen in 2019, given that the tailwinds from dovish monetary policy have abated. More recently, credit concerns have expanded from China’s private sector to state-run firms and university-linked companies (eg Tewoo Group, Peking University Founder Group). To date, such instances of credit concerns have been idiosyncratic and there is little to suggest risks of widespread systemic defaults given the depth of the Asian bond markets. As such, we believe that there are pockets of value that investors can uncover with decent credit analysis to provide a fair return in this brave new world of lower-for-longer yields.
We would encourage investors to consider Asian HY companies with stable, organic operating cash flows and good debt serviceability. The IMF’s growth outlook for broader Asia in 2020 remains attractive at 5.8%, especially when juxtaposed against the 1-2% projections made for DM economies. In mentioning Asia, we also acknowledge the elephant in the room that is the outbreak of the novel coronavirus; while risks to economic growth have re-emerged, we do not expect the negative impact on financial markets to be long-lasting.
Asia BB-rated credits remain the sweet spot. These credits, currently yielding 4-6%, are strong contenders for the income portion of our Barbell Strategy, providing good returns on a risk-adjusted basis. However, in the pursuit of carry assets, we reiterate that investors should not be carried away by high yields alone; sound credit fundamentals remain a necessary protection for downside risk.
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