Asia Fixed Income Investment Outlook – Quarterly Update

Author: Chris Lau, Senior Portfolio Manager

Asia investment grade (IG) credits held up relative well in 1H. In our view, solid fundamentals, strong technicals and the fact that all-in yields look attractive from a historical perspective will continue to support credit markets into 2H.

In recent months, the Federal Reserve (Fed) has been on hold given the strong labor market and stickier than expected inflation in the US. As such, the interest rate trajectory has not panned out as the market anticipated. We believe the Fed will find it very difficult to cut rates until the persistent inflation trend reverses and is set to keep its policy rate higher for longer. The latest hawkish FOMC minutes boosted US treasury yields and the US Dollar Index. Various FOMC members have questioned if policy rates are restrictive enough and have expressed a willingness to tighten policy further if warranted. However, we believe the chances of a rate hike are extremely slim. In our base case scenario, we still expect 1 to 2 rates cuts this year, with the first cut occurring in November 2024. In our view, the macro backdrop is still favorable for risky assets, but the pullback in expected Fed rate cuts could be a headwind for risky asset performance in the coming months. 

Asia IG spreads continued to tighten in 1H, despite doing so at a much more moderate pace, and have reached a new historical tight year-to-date. The JP Morgan Asia Credit Index (JACI) IG spreads have tightened to 80 basis points (as of May 20, 2024), the tightest level since the Global Financial Crisis (GFC). From a spread perspective, Asia IG outperformed US IG on a relative value basis. Spreads between Asia IG relative to US IG have declined to -6 basis points while historical average spreads were in the range of +20 to +30 basis points.

While recent April inflation data showed a renewed disinflationary trend, the Fed will need to wait for more evidence to justify rate cuts. Current data suggests a delayed and cautious cutting cycle. In the medium term, we believe resilient growth, disinflation and the start of easing cycle would be a favorable environment for risk taking. Despite the tight credit spreads, Asia credit remains attractive from an all-in yield perspective after the recent US rates sell-off. We expect Asia IG bonds to continue to perform well in 2H benefiting from stable fundamentals and strong technicals. Receding rate volatility in the latter part of this year should support fund flows in 2H 2024, favoring high quality IG bonds due to attractive all-in yields.

In general, we believe most market participants are aware that current valuations are not cheap, however are still willing to hold on to their positions and would be keen to buy on dips. We think improving Asian economies and stable fundamentals among Asian corporates justify the current tight valuations. We expect that Asian IG credit spreads could be range-bound at +/- 10 basis points for the next half year. Our biggest concern is still on the rates side should ten-year US treasury yields trend toward 5%, and rates stay higher for longer.

Economic activities showed resilience in ex-China Asian economies and most Asian IG issuers have stable fundamentals. Headline and core inflation has continued to moderate across Asian economies so far this year. However, Asian local currencies have shown weakness year-to-date due to the unwinding of - Fed rate cut expectations and broad US dollar strength. The risk of delayed policy easing is rising, and Indonesia and Taiwan have already surprised the market with rate hikes this year. US dollar strength could force Asian central banks to maintain more restrictive policies to defend their currencies. 

Following the notable spread compression in the last few months, many BBB corporate credits are at multi-year tights. The broad market no longer offers decent risk-reward potential in our view. BBB corporate credits have tightened significantly year-to-date due to relative value buying interests and generally improving fundamentals. We recommend switching from BBB corporates to higher-quality names or BBB financials. Despite overall tight valuations, there are still pockets of value available in selected new issues including Korea, Japan, and Australian banks Tier-2. We also see attractive relative value in Hong Kong corporates and financials with cheap valuations. While Hong Kong credits had been underperforming the rest of Asia, the outlook for this market is stabilizing following the removal of extra stamp duties in the property sector. We believe refinancing may also benefit from improving local liquidity.

Technicals remains strong in Asia’s credit space due to negative net supply. We expect Asia IG primary supply to remain limited in most countries, particularly for corporates. Elevated US dollar funding costs will prompt Asian companies to use internal cash or turn to onshore funding channels for cheaper funding costs. This should further shrink the investment universe. We expect to see a divergence in credit spread performance between different Asian countries and China. Technical support for China onshore IG credits should remain strong given the government’s accommodative policy stance. Yield differentials and limited new supply in the offshore market are also prompting onshore investors to increase their allocations to China offshore USD bonds, particularly state-owned enterprise bonds.

Asia IG credit should continue to be supported by stable fundamentals and strong technicals and we think yield carry looks attractive on an all-in perspective. While we do not see scope for material spread compression in Asia IG from current levels, we believe the relatively high all-in yields should continue to be supportive for the space in 2024. Most of the return from Asia IG will come from income carry.

Author: Norbert Ling, ESG Credit Portfolio Manager

Asia high yield (HY) bonds started the year off strong and JPMorgan Asia Credit Index (JACI) HY total return reached 9.2% as of May 2024 (Figure 1). Asia HY has significantly outperformed both Europe and US HY bonds year-to-date, the latter two asset classes delivering negative total returns.

Asia HY total return has predominantly been driven by excess returns in the real estate sector, contributing to around one-third of overall return at the index level. However, the yield to worst of real estate names has come down significantly from the high of over 25% in September 2023 to below 17% as of May 2024. For non-real estate sectors within the HY index, year-to-date spread tightening has led to a decline in yield to around 7.5%, which is lower than that of the US HY index. 

We home in on three key themes that we believe are worth keeping an eye on for investors looking at Asia HY bonds in H2.

1. Focus on income and preference for short-dated high yield paper;
2. Resurgence in HY supply, but credit selection is key;
3. Relative value between Asia HY and Asia IG.

Focus on income and preference for short dated high yield paper

As highlighted in our 2024 Investment Outlook, security selection is critical so investors can identify resilient business models with strong fundamentals that can operate in a higher interest rate environment. Considering this, we are optimistic on HY-rated companies which generate free cash flow over and above their short-term debt maturities, and we believe that short-dated HY paper from these issuers can provide attractive risk-adjusted returns for income-focused investors.

Within the short-dated HY bond space, we see opportunities to invest in Asian national champion banks across the capital structure that are well capitalized and provisioned, as well as in the Macau gaming sector where issuers remain in deleveraging mode as earnings recovery continues apace. We also see good opportunities in Indian renewables after the recent spread correction.

Resurgence in HY supply, but credit selection is key

As discussed in our Q2 outlook, the tightening of spreads has lowered all-in financing costs for Asia HY corporates. This is likely to spur more Asia HY issuance and offer new investing opportunities. Total Asia HY supply amounted to US $5.6 billion in 2024, nearly equivalent to the supply of 2022 and 2023 issuances combined (Figure 2). The mix of issuers has changed with Indian issuers accounting for nearly half of total supply in 2024.

While Asia HY spread levels have compressed on a relative basis, this has still been offset by high US treasury yields. This year’s vintage of HY supply has amongst the highest coupons, averaging 8%. This plays to the theme of name selection to capture income with a robust credit underwriting process.

Relative value between Asia HY and Asia IG

When looking at the relative value between Asia HY and Asia IG (ex-real estate issuers), we note that yield pick-up in HY has continued to drop from 3.5% at the end of 2023 to just 1.9% as of May 2024. As such, the additional yield pick-up to be had in the HY asset class has become relatively less attractive. That said, Asia HY bonds still offer differentiated sector and country exposures that are not available within Asia IG bonds, and the higher yields and lower duration are supportive in periods of interest rate volatility. The new vintage of HY bonds with higher coupons could offer attractive opportunities in terms of income and risk adjusted carry in the current period of interest rate volatility.

From our perspective, having the ability to have a flexible allocation between IG and HY will be a key source of alpha, allowing the manager to select the best risk-adjusted credit ideas across all ratings categories and sectors.

Author: Yifei Ding, Senior Portfolio Manager

Emerging market (EM) Asia hard currency sovereign bonds continued to trade tighter in 1H 2024. This asset class has been trading at the tightest absolute levels since the Global Financial Crisis (GFC) (Figure 1). The overall universe of EM hard currency sovereign bonds has also been trading tighter. However, the current Emerging Markets Bond Index Global Core (EMBIG) spread is quite some distance away from its post GFC tight.

EM Asia sovereign issuers’ credit fundamentals have been improving in recent years. However, the relative value between Asia and rest of EM has become less favorable. We have observed balanced technicals in EM Asia hard currency sovereign bonds, as capital outflow pressures and net redemptions have largely offset each other. Yet on the demand side, global capital has been flowing into developed markets (DM) bonds instead of EM and Asia in particular, largely due to valuation concerns.

Local investors across Asia, on the other hand, are keen to buy USD bonds issued by their own governments. As local governments in the region have either seen improved fiscal conditions in recent years, or are facing cheaper funding options domestically, the issuance volume of hard currency sovereign bonds has been low in Asia compared to the other EM markets.

The current global macro backdrop seems to be in a steady state. Market consensus is that DM are likely to go towards the soft-landing scenario while the EM macro-outlook also does not give much cause for concern. With this base case, we expect the rest of EM to outperform EM Asia hard currency sovereign bonds as risk assets are likely to benefit from the stable macro environment. In the unlikely scenario where the market sells off, we believe strong local demand will help EM Asia sovereign bonds to outperform other regions.

Rather than hard currency, we are more positive on Asian local currency bonds. Asian local government bond yields have been trading at relatively high levels given the wide US Treasury and other DM government bond yield curves. These high absolute yield levels are attractive for local investors looking for risk-free returns. Most Asian countries have raised interest rates in recent years as global inflation has become rampant and major central banks like the Federal Reserve (Fed) have kept rates high.

For domestic investors, Asian local government bonds offer attractive yields relative to historical standards. In general, Asian governments have been doing well in recent years in terms of delivering on their macro and fiscal targets. Another factor that is propelling demand is demographics. Most Asian markets are witnessing a rapid growth in middle-income households, driving record investment demand. As Asian local government bonds are risk-free for domestic investors, these are logical investment targets for this new crop of investors.

At the same time, we admit that the relative yield pickup of this asset class against US Treasuries has not been as attractive, with the Fed staying put on interest rates amid domestic inflationary pressures. We expect international investors to find Asian local rates attractive once the Fed and other DM central banks start to cut. Nevertheless, we believe the recent USD rally will fade before year end as the market has re-priced the Fed cutting cycle for the remainder of the year. The recent underperformance in local currency EM Asia government bonds has largely come from exchange rates. Once the USD rally fades, we expect to see positive performance potential from Asian local currency government bonds in USD terms.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

When investing in less developed countries, you should be prepared to accept significantly large fluctuations in value.

Investment in certain securities listed in China can involve significant regulatory constraints that may affect liquidity and/or investment performance.