Asian Investment Grade Bonds: Stable fundamentals with rich valuations

• We see a stable growth-policy mix for Asia, with weakness in China counterbalanced by strong growth prospects in countries like South Korea.

• Corporate issuer fundamentals within the Asian IG space remain solid.

• Credit spreads within Asian IG remain fairly tight relative to history, making credit selection crucial for investors.

• We recommend Manulife’s Asia Pacific Investment Grade Bond Fund for an active approach to Asian IG.

The performance of fixed income as an asset class has improved this year following a historically weak performance in 2022 (performances are based on Bloomberg indices in LCY terms). This improvement was supported by several factors like: (i) increased demand for defensive assets amidst weakening global growth; (ii) a slowing pace of rate hikes across the world; and (iii) higher nominal yields relative to the past years which increased the broad attractiveness of the fixed income asset class.

Asian Investment Grade USD-denominated (Asian IG USD) bonds have held up well this year with a +1.7% YTD performance (as of 18 Aug). This contrasted with the Asian HY USD bond market which saw a decline of -1.8% YTD, likely due to the latter’s higher exposure to distressed Chinese property names which have suffered from a lack of concrete supporting measures from authorities thus far. In addition, the Asian IG segment also outperformed the Global IG segment (-0.5% YTD), likely helped by the former’s lesser exposure to duration (Chart 1).

Looking ahead, we think the Asian IG continues to see stable fundamentals, especially when compared to its Asian HY counterpart. We nonetheless warn that credit spreads have tightened over the past year, and recommend the Manulife Asia Pacific Investment Grade Bond Fund, an active strategy which can help to tap into opportunities in this diverse market.

Chart 1: Asian IG bonds have held up relatively well in 2023

Breakdown of Asian IG USD Market

The Asian IG USD market contains a fairly diverse range of countries as well as sectors (as of 17 Aug). Geographically (based on underlying exposures), the segment has a large allocation to China (43%), followed by South Korea (13%) and Indonesia (12%) (Chart 2). Unlike the concentrated exposure to China’s property sector within the Asian HY bond market, there is a diversified exposure to China’s corporate higher-quality bonds within the Asian IG bond market. This comprises China’s largest companies, including internet companies like Alibaba, Financials like ICBC, and oil-and-gas (O&G) players like CNOOC.

In addition, we note that sovereigns account for a sizeable part of the Asian IG space (22%), and this is reflected in its top holdings as well, which include government bonds from different issuers like Indonesia, China, and the Philippines (Table 1).

Chart 2: China accounts for a large part of Asian IG (43%)

Table 1: Top allocations within Asian IG USD

Stable outlook for Asian IG

Monetary policy in Asia could be less restrictive than major DMs

Thus far in 2023, Asian central banks have been far less aggressive than major DM central banks in hiking policy rates. While major DM central banks have hiked policy rates by 100 bps to 200 bps YTD, many central banks within Asia have hiked rates by a significantly lesser amount. For instance, South Korea and Indonesia have hiked their policy rates by 25 bps each YTD, while China has even begun cutting its policy rates recently with two cuts to its 7-day RRP rate (10 bps each) in Jun and Aug 2023 (Chart 3).

One reason that has allowed Asian central banks to take on a less aggressive monetary stance is that inflation within the region looks better controlled compared to that in major DM markets. This is reflected in the comparison between central bank inflation targets in each market to two readings: (i) latest inflation figures; and (ii) consensus analysts’ forecasts for end-2023 inflation for the respective market.

In both cases, inflation within Asia relative to central bank targets generally remains more benign (Chart 4). Overall, the inflation outlook in Asia gives Asian central banks more room to turn less hawkish than major DM central banks. Looking ahead, this means that Asia’s monetary policy will likely be less tight and financial conditions less restrictive, which should weigh less on both Asia’s macro outlook as well as issuer fundamentals.

Stable growth outlook across Asia, but weighed down by China

On the macro front, we acknowledge that China – which forms a large part of the Asian IG universe – faces several macro challenges. We have highlighted multiple reasons to be cautious on China’s growth outlook in recent articles, including extremely fragile confidence among Chinese consumers as well as limited scope for additional policy support. Despite this, we still expect positive GDP growth numbers for 2023, largely due to a low-base effect and given two-quarters of positive quarterly growth, considering that China was under a strict lockdown for most of last year. That said, we still expect China’s growth to be lacklustre this year. 

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More importantly, despite the challenging macro backdrop in China, we are more optimistic on growth in several other parts of Asia. For instance, we have identified countries like South Korea and Singapore as “Asian Tigers” - countries to watch for their growth potential. We expect the economies of both countries to benefit from the incoming semiconductor cycle trough, while Singapore can also capitalise on its status as a global / regional financial hub and maintain a relatively resilient growth outlook.

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Chart 3: Asian central banks have been much less aggressive compared to US / EU / UK

Chart 4: Asian inflation looks better controlled compared to major DMs

Corporate issuer fundamentals remain solid

On an issuer basis, we find that corporate fundamentals remain solid. A large majority of corporate issuers within the Bloomberg Asian IG USD Index (about 89%) remain profitable (i.e. positive EPS). In addition, more than half of these corporate issuers saw positive growth in sales (74%) and EPS (60%) over the past year, and positive growth in sales (82%) and EPS (79%) over the past 3 years as well. Profitability from many corporate issuers within the Asian IG universe today has not only rebounded from the pandemic era, but the earnings momentum has also continued over the past year.

Looking at corporate balance sheets, we find that net debt levels have increased this year, led by higher levels of gross debt with cash levels remaining fairly stable cash. We attribute this to weakening macro conditions. Despite so, we find that aggregate net gearing ratios have held steady when compared to pre-pandemic levels.

Resilient credit metrics and improved profitability have likely supported credit qualities within the Asian IG space. So far in 2023, the Asian IG space has seen 3 upgrades compared to 2 downgrades, implying an upgrade/downgrade ratio of 1.5X. This is one of the higher ratios compared to other bond markets, including the US IG segment (1.3X), as well as many other high-yield segments (Asian HY: 1.0X) (Chart 5).

Chart 5: Asian IG segment has seen an improvement in upgrade/downgrade ratios

Valuations remain tight

Nominal yields within the broader Asian IG USD space have climbed to relatively attractive levels, trading at a YTW of about 5.9% (Chart 6), in tandem with the sharp rise in UST yields due to the Fed’s rate hikes over the past one to two years.

However, option-adjusted spreads remain fairly tight relative to history – they are currently trading at late-2019 ranges before the COVID-19 pandemic, but after the peak of US-China trade war tensions (Chart 7). Asian IG bonds, on aggregate, are trading at a spread of 127 bps as compared to a long-term average of 151 bps. We think these tight spreads are a result of a move towards quality globally and within the Asian fixed income universe, considering Asian HY exposure to the Chinese property sector which has shown little signs of a meaningful recovery.

Despite the relatively tight spreads in Asian IG, we continue to prefer this segment over Asian HY for its relative safety. We think that Country Garden’s recent default further underscores the significant uncertainty within the Chinese Property and Asian HY segment – this contrasts greatly with the Asian IG USD space which has much lower exposure to the Chinese Property segment and instead has greater exposure to sectors like Financials and O&G. Overall, we believe that credit selection remains critical in the Asian bond space, given both the tight spreads within Asian IG itself, as well as the large differences in fundamentals between Asian IG and Asian HY.

Chart 6: Nominal yields have climbed over the past two years …

Chart 7: … but spreads for Asian IG USD have tightened as well

Consider an active allocation to Asian IG to tap into opportunities

To summarise, we see a stable outlook for the Asian IG universe, even though China’s outlook remains fragile. We are also cognizant of fairly stretched valuations within Asian IG at the moment. The uncertain macro situation in China, as well as tight credit spreads, highlight the importance of both top-down allocation and bottom-up credit selection within the Asian IG universe. We recommend the Manulife Asia Pacific Investment Grade Bond Fund, which stands out for its strong historical performance not only against its benchmark but also against its peers (Table 2).

Table 2: Fund performance

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.