Many western investors equate Asian fixed income with the internationalisation of the Chinese bond market. While China’s effort to open up its debt markets to international investors is too big to ignore, the focus on a single development in the region’s fixed income story does a disservice to what has become a varied and challenging market.
Citywire AA-rated Teresa Kong, lead manager on the Matthews Asia Strategic Income and Asia Credit Opportunities funds, says Asia has become much more nuanced in recent years. There are several drivers at play to entice outside investors beyond the seemingly unstoppable Chinese growth, she explains.
‘If you break down the drivers of returns in Asian fixed income, it is down to interest rates, credit and currency. Everything else is a derivative of that. Interest rates are a really interesting category at this point, because last year interest rates in the region were a strong tailwind. Most fell as opposed to rising, which gave a price pop on the bonds.’
While various parts of the world are moving at different speeds in a bid to bring normalisation to rates globally, Kong says investors need to be aware that most Asian markets – except India, Indonesia and Sri Lanka – are in tightening cycles, which could cost short-term performance. However, for managers such as Kong with the scope to buy credit, this is a plus.
‘While Asia credit spreads are hovering around the average, if you look around the world that is not the case. In the US, it is about 200bps below average; in Europe, it is 300bps below average; but it is around the average in Asia.
‘So, there is room for credit spreads to tighten here, but there is no room in the US or Europe, because of quantitative easing. That has driven the demand for yield products down to historical lows, which means Asia is very, very good relative to other opportunities.’
Tapping into her third point – currency – Kong says Asia has shown resilience compared with the US dollar and has even had some breakout performers as the greenback has shifted around.
‘Asian currencies outperformed relative to the dollar and some – such as the South Korean won – performed in double digits. This year, we think the themed growth drivers will continue, but at a much more muted pace,’ she says.
‘What happened last year was driven by this uptick in global growth and people were wondering what happened to the very, very subdued experience of 2015. Everyone was wondering then what happened to global trade.
‘We saw it was cyclical and, as the engines of growth recovered, global trade recovered and that benefited the small economies of Asia. These were the ones that had their currencies outperform the most.’
Picking up on the currency point, Desmond Soon (pictured), head of investment for Asia ex Japan at Legg Mason, believes that 2018 will be the year in which domestic Asian investors look internally for new opportunities. ‘We expect investors to diversify heavily from their concentrated US dollar-denominated bonds in favour of local Asia currency bonds,’ he says.
‘Asian investors in US dollar-denominated bonds may suffer a double whammy of bond capital losses and a depreciating US dollar due to the failure of the US dollar to rally on interest rate differentials. This is while Asia FX is likely to be supported by large current account surpluses in developed Asia and relatively high bond yields in India and Indonesia.’
While Soon predicts a broadening of the domestic Asian investor experience, he foresees growing challenges for bond buyers looking to enter Asia from the outside.
He highlights how both China and India have made efforts to improve their transparency and attractiveness for foreign assets, but it has proved to be a time-consuming process.
‘Foreigners will need to overcome significant documentation requirements, tight settlement timelines and trading procedures to invest in China and India onshore bond markets. Singapore, a major financial centre at the crossroads of these two emerging economies, is poised to play a centre-of-excellence role in the research, trading and settlement of China and India local currency bonds.’
Private banker view
Tam Chun Him Head of fixed income, RBC, Singapore
‘Carry will be the key driver in Asia fixed income this year. We do not expect the price gains we saw last year to be repeated. Investors should be prepared for higher volatility.
‘While Asian credits are rich, they should continue to trade range-bound, given the positive macro environment and stable corporate fundamentals. Asia is able to withstand market volatility better than other emerging markets because of its larger local investor base.
‘We prefer investment grade to high yield. We focus on strong companies and achieve yield by going down the capital structure. We still see pockets of value in China, but credit differentiation will be key.’
However, it is hard to escape the spectre of China and its recent efforts to internationalise its markets. Citywire AA-rated Andrew Seaman of UK group Stratton Street forecast a rapid growth in the country’s debt dynamics more than a decade ago. He says not everyone was as quick to notice this.
‘People are waking up to the fact that China is going to have a huge impact on markets and, more specifically, benchmarks. They are going to find Chinese debt is an increasingly large part of their portfolios. While we would not expect this to jump from zero to 18% overnight, it is going to happen, so you need to position now to be on top of that.’
Soon agrees with Seaman that the media attention on China’s bond market extension has been myopic. ‘The term “internationalisation” is in that sense inaccurate. The Chinese have always taken a gradual and calibrated approach and certainly learned the lesson from the devaluation debacle that occurred in August 2015,’ he adds.
Dealing with a dragon
Looking at positioning, Seaman (pictured), who runs the Stratton Street Ucits Renminbi Bond fund, says there are two ways to play China. The first is through strong dollar bonds in the investment grade space. The second is via the currency, which has performed strongly over the past year despite the market expecting the opposite.
‘There is a belief that as Chinese growth slows the renminbi will weaken, but that has proved not to be the case historically. So, the case for investing in renminbi remains intact. Chinese debt has a high credit rating, so the fundamentals are strong and yields are around 2% to 3%. If the currency continues to be strong – and we foresee no change in this respect – then there is a strong investment case there.’
Henry Wong, head of Asian fixed income for Asia Pacific at Deutsche Asset Management, agrees that the magnitude of China’s bond market moves cannot be overstated.
‘As a matter of significant country weighting in the global local currency bond market, the China domestic bond market is likely to see an initial major reallocation of investment in respect to the domestic bond market, especially for emerging market countries.
‘In 2017, China attracted around US$55 billion of foreign funds into domestic bonds, according to central bank data. Around one-third of the flows came via Bond Connect, Bank of China (Hong Kong) says. Foreigners hold less than 2% of the Chinese domestic debt, but index inclusion will help pull in $700 billion to $800 billion of overseas funds over the next five years, such as central bank purchases.’
Darren Ruane Head of fixed interest, Investec Wealth & Investment
‘We look at Asian fixed income in the context of emerging market debt exposure, which has been growing within UK wealth management firms for a number of years.
‘Investec Wealth & Investment’s preference for access to the strategy is through funds in three main areas: local currency emerging market debt, a blend of local and hard currency emerging market debt, and high-yielding hard currency emerging market corporates.
‘These three strategies cover the bases we require and we are happy to outsource the regional selection decision to the fund managers, who are closest to the investment story. At this point, Asian fixed income strategies on their own are not required, since we access them this way instead.’
Citywire AAA-rated Wong believes a key factor here will be how Chinese government policy plays out over the next few years. While there are obviously implications for its equity markets, any imposition on its debt offering could cause spill-over into the wider Asian bond market, he warns.
‘One of the key elements in investing in Asia would be the impact of Chinese government policy, given Chinese issues represent almost 50% of the JP Morgan Credit index. Not only because government policies affect the business nature of corporate issuers, but also because it will affect the amount of liquidity, at least in the short term, that is being deployed in the offshore Asia US dollar bond market.’
With a multitude of idiosyncratic markets and differing drivers for debt growth, an overarching view is too simplistic, suggests Wong, who runs the Deutsche Invest Asian Bonds fund. Instead, investors need to be more nuanced when dealing with Asian debt.
‘Due to the unique composition of the Asian fixed income space, where the majority of issuers are corporate issuers, it is important to adopt a bottom-up investment approach. This allows us to identify investment targets on individual merit basis,’ he adds.
These comments originally appeared in a supplement published with the March edition of Citywire Private Wealth magazine.