After yields have climbed to 6%, Asian investment grade bonds are starting to look compelling

• The key source of Asian IG debt is China, with the majority of issuers being state-owned enterprises, whose economic values are driven by state policies and are of great importance to the government.

• Amidst an impending global recession, credit fundamentals remain sound and Chinese issuers are entering the economic downturn from a position of rating stability.

• Credit spreads have widen significantly since the start of the year, and Asian IG bonds are also offering a decent yield pick-up over global peers.

• We believe that it is an opportune time for investors to add some Asian IG exposure. Our recommended products are the United Asian Bond Fund which has adopted a defensive positioning, and the ChinaAMC Asia USD Investment Grade Bond ETF (HKEX:3141).

In recent times, we have expressed a positive view on fixed income, with a preference for investment grade (IG) over high yield (HY) in view of the challenging macro backdrop. Within the Asian credit space, our preference for quality remains. We have taken on a more defensive stance on the Asian high yield bond market, and urge investors to take a closer look at Asian USD IG bonds, whose yields have reached a high since the Global Financial Crisis (GFC).

Figure 1: Asian USD IG yield has picked up

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Asian IG offers sector diversification

To get a better understanding of what makes the Asian USD IG bond market tick, we delve into its universe.

The key source of Asian IG debt is China, which occupies around half of the investment universe (Figure 2). The majority of Chinese issuers are state-owned enterprises (SOEs), whose economic values are driven by state policies (Table 1). They are also of great importance to the government – President Xi sees the state sector as the backbone of the economy that can help advance the government’s various strategic objectives.

Additionally, unlike the Asian high yield universe where the majority of Chinese credits are from the property sector, the IG bond market offers more sector diversification. Chinese IG issuers span across various sectors, including financials, sovereigns, technology, and real estate. In line with this, the largest sector within Asian IG debt is financials (26%), while the real estate sector occupies only a thin 3%.

Figure 2: China and the financial sector makes up the lion’s share of Asian IG

Table 1: Top 10 largest Chinese IG corporates

Since the start of the year, regulators have already made several attempts to revive the real estate sector, but indicators in the property market are still painting a dim picture. While China has announced a 16-point plan to salvage the sector, we do not see this as a major turning point. The direction for the real estate sector has not changed, as President Xi remains committed on reducing leverage as well as the sector’s role in China’s economy. We believe that too much confidence has already been lost, and that the real estate sector is far from a meaningful recovery.

As such, within Asian USD credits, investors should consider IG bonds over HY as the former’s diversification across key sectors and sizable exposure to SOEs provides some insulation against the fallout in China’s real estate sector and President Xi’s pursuit of a top-down state-controlled economy.

Credit fundamentals remain sound

Even though Chinese corporates (particularly for private companies) would encounter risk to earnings prospects as China enters a low-growth period, their healthy balance sheets could serve as a cushion. Major constituents across key sectors like China National Offshore Oil Corporate (CNOOC), Alibaba, and Industrial & Commercial Bank of China (ICBC) are still in a net cash position (Figure 3).

Notably, although the profitability of Chinese tech companies have been affected due to the crackdown and zero-Covid policy, their balance sheets remain rather strong. These companies may not make the best investments from an equity perspective, but could make a strong case for fixed income investors.

Figure 3: Some have solid balance sheets

Meanwhile, the credit outlook of companies in the oil and gas and utilities sectors should remain largely stable, as high profits and measured capital spending over the past year have beefed up their balance sheets. In addition, China’s onshore corporate bond yields have continued to tighten as a result of easy monetary policy, supporting Chinese issuers’ access to cheap funding.

With the global economy poised to fall into a recession in 2023, there also comes an increasing likelihood of fallen angels (i.e. a bond being downgraded from IG to HY). We note that a sizable amount Asian IG corporates are currently in the BBB bucket (i.e. BBB- to BBB+). In particular, bonds rated BBB- (9% of the Bloomberg Asia USD Investment Grade Bond Index) which are considered as borderline IG and most at risk of becoming fallen angels.

(Related article: A global recession is likely unavoidable in 2023. Here’s how you can prepare for it.)

Year-to-date, credit events (especially those that happened at a rapid pace) have been largely attributed to China’s real estate sector. For example, the only downgrades from IG to HY made by Fitch Ratings in 3Q22 were Country Garden and Sino-Ocean Group, as these property developers face deteriorating financial flexibility amidst the challenging operating and financing environment. With the now smaller role of Chinese real estate in Asian IG, one could argue that the wave of downgrades may slow moving forward.

Major Chinese IG issuers are entering the global downturn from a position of rating stability, as they are generally rated A- and above, with a generally stable outlook, by the three major credit rating agencies (Table 2). Furthermore, according to S&P, the number of potential fallen angels (rated BBB- with negative outlooks) in among non-financial issuers in Asia Pacific is lower as compared to a year ago. Essentially, not all is doom and gloom still.

Table 2: Credit trend of major Chinese issuers remains stable

Valuations are undemanding

Throughout the year, the credit spreads of Asian IG debt have widened significantly on the back of the Russia-Ukraine conflict, global inflationary pressures, as well as elevated tensions between the US and China. Following this repricing, spreads are now at their highest levels since the pandemic and are also close to one standard deviation above the 10-year average (Figure 4).

Figure 4: Valuations of Asian IG have improved

Widening spreads, coupled with higher rates, have pushed up bond yields to levels not seen since the GFC. At 6.0%, Asian IG debt offers better yields as compared to fellow US and European counterparts. The yield differentials also have widen over the past year (Figure 5). A year ago, the yield differential between Asian and US IG was slightly over 75 basis points (bps). Today, Asian IG sports a yield pickup of more than 120 bps over US IG. On a similar note, the yield pickup Asian IG has over European IG increased to nearly 290 bps from 210 bps.

Figure 5: Asian IG provides a decent yield pickup

Unlike HY bonds, IG bonds tend to be less vulnerable to economic downturns due to their higher credit quality and flight-to-safety. As such, we do not expect the spreads of Asian IG to widen substantially as compared to HY counterparts in the event that global economic conditions slow more dramatically (e.g. a recession). With valuations becoming more undemanding today, we believe that it is arguably an opportune time for investors to add some Asian IG exposure.

Key investment risks

More aggressive rate hikes: Persistently high inflation prints could lead to larger-than-expected hikes, dragging down on returns in the bond market. Nonetheless, we note that Asian IG is less rate sensitive as compared to global peers due to its shorter duration profile. Combined with higher yields, Asian IG debt also has a higher yield per unit of duration (i.e. more buffer to offset the rise in rates).

Table 3: Asian IG has shorter duration

Recommendations

We believe that Asian USD IG debt is looking more compelling. While not all risks (such as the probability of a recession) have been reflected in valuations yet, today’s bond issuers with their sound credit fundamentals are in a good shape to weather the uncertainties. Therefore, investors should consider increasing their allocation towards Asian IG.

Our recommended fund is the United Asian Bond Fund which selects credit based on their fundamental bottom-up research. The fund has also adopted a defensive positioning with a preference for quality credits with leading market shares and systemic importance in defensive sectors, which translated to a modest yield of 5.6% (as at 30 October 2022). While investors are free to express their currency views, we recommend the SGD-H share class for Singaporean investors to prevent their yield from being eroded by currency movements.

Meanwhile, investors who prefer a passive approach can consider the ChinaAMC Asia USD Investment Grade Bond ETF (HKEX:3141) which tracks the Bloomberg Asia USD Investment Grade Bond Index that averages a yield of approximately 6%.

(Related article: United Asian Bond Fund: Welcoming back a previous 7-time Recommended Fund)

Table 4: Recommended products

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.