IFR Asia Outlook for Asian Credit Roundtable 2019: Part 1

IFR ASIA: Welcome everyone to IFR’s roundable on Asian credit. We’re here to find out what is driving this robust rally in Asian credit. How long will it last, and what are the challenges this growing market faces? The pace of this rally has been really surprising for market participants, even the most optimistic of us. KJ, what do you think?

KJ Kim, ANZ: That’s a good question. Last year was an interesting year because it was the first time we saw quite a bit of sustained volatility and uncertainty in the markets where issuers and investors were truly tested. With the volatility in rates, the uncertainty with the Fed’s direction, coupled with the US trade war dynamics, there was a large amount of unease that had built up, and at the back end of the year we saw a test of how well technicals would hold up against these growing concerns.

So far this year we have seen favourable technical factors, particularly the supply-demand dynamics and better valuation for investors, outweighing any diminishing uncertainties surrounding fundamentals. US trade war tensions are easing and there is more confidence around the Fed’s outlook for the year. As a result the liquidity in the primary and the secondary markets has been outstanding in the first two months.

The key question is whether the rally will last – in my view, we will see a similar pattern this year to the last couple of years. We typically find that at the start of the year, there is a lot of liquidity in the system and this year, we have been helped by a large portion of Chinese issuers staying onshore for their issuance. If you look at the mix of China’s SOEs and IG corporates, versus high yield, those dynamics have played in the favour of offshore capital markets.

The positive sentiment may last a little longer for the short term. In my view, uncertainties will start creeping back in again: there will be growing questions about the Fed’s stance, the overall global fundamentals outlook, and elections in countries like India, Indonesia, Thailand and Australia will no doubt raise questions around the political direction. Liquidity is likely to hold up, but the supply is expected to be larger this year versus what we saw last year, particularly with the redemption calendar coming through. We will probably start seeing a bit of a tapering of the rally towards year-end.

IFR ASIA: Ed, what is your outlook for primary issuance, and what can you tell us about the changes in direction of Chinese capital?

Ed Tsui, Deutsche: There were two key factors that prompted this year’s rally. In the second week of January, the Fed changed from being a headwind for EM credit last year to a tailwind when the Fed chairman hinted that the Fed will consider market reactions when raising rates. That was a 180 degree change in narrative.

The second big factor was that going into the year, most asset managers were under-positioned versus the benchmark. Last year, you beat the benchmark by holding a higher proportion of cash. This year, many funds were holding too much cash and/or holding shorter duration portfolios so funds had to catch up and deploy capital in a more aggressive way.

In terms of China flows, last year was an outflow story. The marginal dollar from Chinese investors was going back to the onshore bond market, which was very strong. If you look at 10-year CGBs, it went from 3.9% in the beginning of last year to 3.2% currently, but this year the narrative is different. The rally in the onshore bond market is less definitive and a lot of the capital gains may have been captured already.

This year, we hear from investors that there are RFPs going out for bond fund mandates coming through QDII quota and from offshore corporates/high-net-worth individuals. We are seeing some of the marginal dollar coming back into the Asia offshore credit market, which has been contributing to the rally.

In terms of this rally, the pace of re-pricing will slow down from here on. There was a massive re-pricing early on this year. There was US$14bn of EM credit inflows, or US$2bn average a week, so I don’t foresee the same magnitude ahead. But I expect secondary levels will be fairly stable on a tightening bias going forward. The fact that the Fed is not raising rates is helpful to Asian FX, and that we are in a decelerating global growth and low inflation environment means you’re supposed to be in EM credit. Where we might start to see some credit spread widening is if we see some earnings disappointment or slowdown in global growth at the back end of this year. That’s when credit spreads may start to widen.

Cliff Tan, MUFG Bank: It’s interesting because, despite the rally, I still get the feeling that people are underinvested in both equities and fixed income.

IFR ASIA: It’s great that the investors are here to help us answer these questions. Do valuations look attractive to you? Why are we seeing such a huge amount of supply being so well digested right now?

Monica Hsiao, Triada Capital: On the trading of technicals, we did sense by last year-end that there were quite a few funds of our type that still were short or underweight on the beta-oriented bonds, and many started to chase to add only by the second half of January. Also I think, from the street dealer side, it did not feel like many brokers held much inventory through the end of last year, so the street positioning probably helped contribute to set up for this rebound.

On our side, we did put our money where our mouth was at the end of last year. I thought then that things were very cheap fundamentally, and I put myself out on record to say it was the best time to buy into Asia credit last December after seeing last year’s dramatic re-pricing. I think that particularly in the last half, post some of the announcements of China policy easing – even though we would agree that for every dollar that is put in we may not be getting as much productivity out of any sort of easing or infrastructure spending – the fact is that there was a turn. It was certainly a turn from putting a pause on the deleveraging side, which helped.

The other factor, I would say, is that not enough attention was paid to the fact that onshore yields had dramatically decreased and more channels were open to some of the high-yield issuers that we were tracking to be able to access certain channels of financing.

The other thing to keep in mind is that last year, never mind what was publicly placed, there were a number of private placements and certain clubby deals. So, I think there was a lot more liquidity there to actually take down debt and provide financing for some of these issuers than would have been seen on record of bond supply.

Fundamentally, if you even look from a ratings perspective, we saw more upgrades than downgrades in the first half of the year in a number of the property developers.

There certainly was justified fear from the number of defaults increasing. That said, I don’t think we should have thrown out the baby with the bathwater and so we saw spots to pick. I think that coming into this year, as others have already noted, I think the Fed Put kind of coming back, helped. That’s certainly supportive for broader EM. Within broader EM, Asia did really look cheap. If you look at the premium, even today, even post this rebound, Asia high-yield is still providing a premium of somewhere in the range of 500bp spread on the high-yield side. Personally, I don’t think Asia high-grade (on a T-spread) is as attractive if you compare it to other markets.

I think also that, if today we still can find two years and under duration – modified duration – paying high single to double-digits, and you can be comfortable with their ability to refinance, as well as looking at their top-line revenue growth and so forth, we still can find spots that are relatively cheap.

The next leg now will be determined, I think, by the continuation of the technicals of the flows. As always, what we do is really about stock picking, so I think in every environment there are still going to spots to be picked.

I look at this year to date; and we’re up almost 7% on a net returns basis through February, and we achieved this on practically no leverage – and also on a book with average duration of under two years. Last year you just had to look at the number of high-yield curves that were reflecting an overly high probability of default, and I would argue it was completely unjustified to have some inverted and flat curves that made bonds look super cheap in the front particularly.

Cliff Tan, MUFG Bank: The Fed’s on hold for a while. You shouldn’t be this short duration, should you?

Monica Hsiao, Triada Capital: It’s a good question as to what optimal duration to hold today when looking at risk-reward of spreads. I don’t know about ‘should’. I would say that we’re constantly monitoring both the technicals and the fundamentals. Fundamentally you can argue about where that extension risk should be from two-year to three-year, and three-year to four-year, which will shift with beta.

I would say that, in the first half of last year, people were still looking at what that normalised curve theoretically would be for every year extension. We used to bootstrap on an average spread per year. Today we wouldn’t do that. Today we would be very much having a view of a tailored spread of where one to two, two to three, and three to four would be, which would be relatively different.

If you look at the Double B space today, you are still getting anywhere between 30bp and 60bp that we have been able to see on extending from three-year to four-year, on average, which you can argue is fair to still cheap, although in absolute spreads, the bonds have rebounded a long way back to March levels of last year. But I would say that, because of how much has been issued in the front end – particularly 360-day paper last year – you can argue that the wider range may actually be justified, as well. So, I’m not sure I would say that extending duration that much is necessarily that desirable now on a risk-adjusted spread basis.*

On the Single B side, I would say I still find more value because we are seeing some extension risk priced at 50bp–70bp on average. So, yes, you could argue it’s cheaper, but then the Single B names there have more fundamental concerns. We are investing in longer duration now, in certain names, but I wouldn’t say we are comfortable with extension risk across the board yet.

IFR ASIA: Morgan, last year investors saw longer duration as a risk, even for the high-quality names. What is your view on duration right now?

Morgan Lau, Fidelity: If we looked at the older HY bonds issued early in the decade, we would see higher coupons like 8%–9%, or even in double digits. Having come down drastically to the 5%–7% level three to four years ago, household high-yield names are now issuing at similarly high coupons again.

For HY funds like ours, high-coupon bonds are good for providing income. Longer duration bonds are quite attractive from an income angle because we don’t have to worry about reinvestment risk.

But we are not seeing enough of those longer-duration, high-coupon bonds, because there weren’t many issuances during the rally in the last couple of months, and the rally ran so fast that the coupon may not be attractive enough, should a longer dated issue come out now.

Hopefully, if we see the rally slow down, we can see good yielding new issues coming for another few months.

In the last few months, many EM and HY funds saw inflows. I think this rally in EM is running ahead of the Asian market, from a simple measure of the spread ratio between EM and Asia. If you look historically in the last three to five years, EM spreads are actually tight relative to Asia from the spread ratio.

We have seen more EM sovereign and EM high-yield borrowers issuing. That’s going to put pressure on the rally for EM, whereas Asia has some way to go. At the beginning of the year, when you looked at the index yield, we were at 10% and so when you’re looking at high-yield and short duration, it’s going to be quite attractive for many investors. Right now I think we’re back to about 8% for high-yield bonds. Given the much lower expectation of rate hikes, I think 8% and potentially lower would still be quite attractive.

At the beginning of the year some investors were relocating their investment into corporate bonds, and that could partly be where we saw the inflows from. Some investors are still sceptical of the rally in the equity markets, so we could still expect more allocations into the credit market.

If 2018 was the perfect storm for fixed income, the beginning of 2019 was, sort of, the reverse of that. We’re seeing interest from PB and institutional clients. Even guys that would normally do more conservative investments are enquiring about more risky mandates.

I think the Asian capital market has developed to the point where fixed income has moved from a speculative asset class to a regular asset allocation. With all these factors, my view on the rally is that it has a bit more to go.

KJ Kim, ANZ: In terms of duration, it’s a fine balance between what the investor wants to see and how the issuer feels about duration and valuation. Last year, over 50% of issuance was in the one to three-year tenors. Issuers who may have wanted to go longer chose not to, because of where valuations were.

For this year, with the rally in spreads and, as Cliff suggested, with the view that the Fed is on hold, appetite for duration may be better. We’re seeing heightened demand on the longer end of the curve and as a result better relative value for issuers, which hopefully will fuel issuance at the longer end. We want to see more duration, because last year we saw an oversupply in the short end.

IFR ASIA: Michael, how do credit fundamentals fit into what we’ve heard so far?

Michael Taylor, Moody’s: Towards the end of last year, when we had such a dire outcome in the markets, there were three big fundamental issues that were really driving things. The first one was the Fed.

The second factor, which we haven’t talked about, was trade and the growing trade tensions between the US and China, which I think weighed on sentiment very heavily last year. Again, that came as a bit of a surprise because we went through the first year of the Trump administration, where the rhetoric from the campaign hadn’t really carried through in terms of policy.

Then, starting round about this time last year, that’s when we started to see the policies actually being adopted that led then to a recalibration in terms of what the global growth outlook might be, the possibility of further tensions between the US and China. That certainly weighed on market sentiment.

Then the third fundamental which came into play was the slowdown in China, which to a large extent was domestically generated. It wasn’t as a result of the trade tensions, but it was as a result of the deleveraging policy and the attempt to address financial risks.

Again, we started off last year with a very strong print in terms of China’s GDP numbers: first quarter 6.9% growth. Everyone started to get very optimistic about this deleveraging campaign going on, but it isn’t really having a big impact in terms of GDP growth. Which was a bit perplexing because, when you started to see how tight credit conditions were on the mainland this time last year, to get that kind of growth outturn didn’t really make a lot of sense.

I think essentially what happened was, towards the end of the year, the GDP numbers started to catch up with where we were in terms of credit conditions. So, we had these three big fundamental factors weighing on the market towards the end of last year, and they all came together. To a certain extent, what’s happened this year is that they’ve all retreated at the same time.

We have seen a diffusion of the trade tensions, and our baseline expectation is that there will be some kind of agreement.

That’s not going to be the end of the story. It’s going to come back again because these tensions are about a lot more than just trade, but, as far as the immediate trade concern is concerned, that seems to have been pushed back as well. Then we’re starting to see in China some of the policy towards stabilising the growth rate – not so much in terms of monetary stimulus, where the PBOC is still being quite cautious, but we have seen a bit of a pullback in terms of the regulatory clampdown on shadow banking, and we’re seeing more fiscal stimulus coming through.

It’s a bit different to last time. It’s not a big infrastructure investment push. It’s more in terms of tax cuts encouraging consumption and at the moment it isn’t clear how well that will work. Nonetheless, I think again market sentiment has improved because the authorities have been taking these actions to try to stabilise the growth rate and to prevent growth in China slowing down too much.

Cliff Tan, MUFG Bank: They ‘cautiously’ added 5% of GDP in credit and loans in January. They’re being very ‘cautious.’

Michael Taylor, Moody’s: We’re not seeing a big reversal.

Cliff Tan, MUFG Bank: It’s a joke, but 5% of GDP is 60% in a year of credit and loans, so, no, I don’t agree they’re being cautious at all.

Michael Taylor, Moody’s: My point, really, was that we had these three factors, these three fundamental factors that were weighing on the market last year. To a large extent, so far this year they’ve been pulled back. I think that’s been one of the things that have supported the market.

Cliff Tan, MUFG Bank: Michael, sorry, I was not actually disagreeing with you. From our point of view, China has been easing since about May last year, so in my write-up I’ve called it ‘Chinease’. I think deleveraging is, to my mind, largely a myth because, if you look at aggregates of credit around China, they’re just continuing to rise and so it’s really hard to see where the deleveraging is.

Michael Taylor, Moody’s: I think the numbers around shadow banking have certainly been impacted by the deleveraging campaign.

Shadow banking has fallen from a peak of 87% of GDP at end 2016 to 68% of GDP at end 2018. That has been compensated for – well, partly compensated for – by an increase in bank lending, in formal bank lending. There’s been a, sort of, switch from shadow banking to formal bank lending, but then the problem that the Chinese authorities face is that shadow banking performed a very important economic function, which was that it provided credit to sectors of the economy which weren’t very well served by the formal banking system.

Cliff Tan, MUFG Bank: The Chinese have announced that they want the state-owned banks to set targets by the end of this month for lending to the private enterprises. This is, by the way, the first time in the history of modern China that I’ve ever seen the government care about the private enterprises.

They want to set this target at around 30% year over year, by the end of this month [March]. Growth in lending to those companies last year was 21%. That’s not enough. I just see a lot of fan dancing here, a lot of reality versus fiction, and I don’t really like some of what I’m hearing.

IFR ASIA: You also talk about how you find very little effort from the government to deleverage. Can you talk more about that, and why that’s problematic, and how that could impact us?

Cliff Tan, MUFG Bank: As I said, we had these nosebleed kind of numbers in January in China in terms of both loans and aggregate social financing. Before the global financial crisis – you guys were all around – you might want to remember that aggregate social financing for China for the whole year was a number like around Rmb4trn. Now we’ve gotten to a stage where aggregate social financing for January was Rmb4trn.

The problem with that is that probably my guess is that half, maybe 60% by now, of that credit is just being used to roll credit. It’s not actually going into new economic activity. Then, on top of that, more recently we’ve got the government worried about wage arrears, which we hadn’t seen for a while. That means workers aren’t getting paid, so a lot of this money is going to pay off workers for back wages, which will help. It will, maybe, slow down the fall in consumption, but it’s not new economic activity, so that’s one of the problems.

Our sense is that even the state banks, these monsters, these giants, are actually becoming more and more like regular companies. They care about profit and loss. They would like to be a regular business like everybody else. As part of that, they care about credit risk, so, when the government tells them, “lend,” to these guys who can’t get money any other way, they’re going to be going, “Hmm, do I really want to do that?”

I think there is a lending strike, even by the big banks, which is why the government’s been on the hobbyhorse: “Please, you’re not doing your job. You’re not lending to the private companies. You’re not lending to the SMEs.” I’m thinking, “When have I ever heard the government care about the private sector and the SMEs?” The answer is never. I’ve never heard that. This is just a politically correct way of saying, “Lend, okay? It doesn’t matter who you lend to.” Anyway, so the banks are being very rational.

China may find it very difficult to use the old tools to stimulate the economy. I think the bang for the buck is going to go down this year.

Monica Hsiao, Triada Capital: But I guess I would argue that the Chinese government is realistic enough that they’re not necessarily expecting to stimulate in order to achieve that much growth. Their goal is more to stabilise. I think stability of the credit markets is a pretty high priority for them. For them to implement the reforms that they want to, they have to guarantee interbank liquidity, for example.

We’ve seen the recent policies where they’ve expanded the definition of what they can accept for collateral. Things like that are really about ensuring that the credit markets are functioning. That’s their goal, which I would argue they are achieving right now.

As Morgan alluded to, I think this is the year where it should actually be quite favourable for us in Asia credit – not only just from the backdrop of EM markets but mainly because we do have, effectively, Chinese QE, and again not necessarily for growth but for credit stability – so that at least we can return to look at credit differentiation and fundamental value.

Forward looking, I would say that credit for this year still would be, relatively speaking, more attractive than equities, exactly to Cliff’s point about growth. To Michael’s point, I do agree that a lot of this – the deleveraging and not only the actions but the talk of the deleveraging, and the shadow banking and so forth – it really definitely limited the access to capital from some of the high-yield issuers that we saw last year, particularly through trust financing, right? The availability of that, we saw, started to come back end of last year.

You can argue about whether trust financing is good or bad, but the reality is it was serving a purpose that the banks were not doing. I think it’s great that there is a lot more talk and lip service to providing more financing for POEs, but, like you said, the banks are cautious about where they’re going to lend to.