China

The allure of Asia

Asian credit is an asset class linked to half the globe’s population and an increasing proportion of the economic value chain – but investor exposure has not kept pace.

Oct 27, 2020

6 minutes

Wilfred Wee
Alan Siow
Asian credit is an asset class linked to half the globe’s population and an increasing proportion of the economic value chain – but investor exposure has not kept pace.

Asian credit call to action

  • Asian credit is under-owned and offers an attractive valuation proposition
  • It supplies lower leverage and volatility, attractive annualised returns and smoother drawdowns than developed market (DM) or broader emerging market (EM) credit
  • Asian credit is not a replacement for owning equities, but is more defensive, reflecting a high proportion of sovereign and quasi-sovereign issuers
  • China focus – current market growth fuelled by index inclusion and passive flows
  • Offshore investors own only 2% of the China onshore bond market; the equivalent figure in most developed markets is 18%-60%

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Drivers of growth in Asian credit

Over the past decade, Asian credit markets have expanded significantly, fuelled by EM growth and the dominance of the US dollar as the global lending currency. In corporate credit, for example, Asia has increased its share of the overall EM corporate debt market from 25-30% to more than half. It also accounts for most of the growth of the market. Yet most investors have a greater familiarity with emerging markets through equities, and limited involvement in the region’s hard or local currency credit markets.

Asia accounts for half the global corporate credit market by value, and most of the growth

Figure 1. Growth in EM corporate bonds (US$ bn)

Growth in EM corporate bonds

Figure 2. Diversified opportunity set

Diversified opportunity sets

Source: Ninety One as at 30 September 2020.

Asian credit exposure provides a number of distinct and desirable characteristics. Regional companies that issue credit are often highly diversified and have attractive Sharpe ratios, while registering lower levels of net leverage compared with global EM credit markets, or those in DM. In contrast, EM equity is essentially a local-currency denominated asset class. Regionally based companies generate revenues and profits in their home currencies, so arguably they are more vulnerable to macro-economic and geopolitical events in their home markets. US-China friction continues to weigh on regional sentiment, but expectations of a China-led recovery have helped the recent performance of Asian equities, led by information-technology stocks in Taiwan.

Asian credit has delivered superior risk-adjusted returns over the past 10 years

Figure 3.

Asian credit has delivered superior risk-adjusted returns over the past 10 years

^Sources: Bloomberg, Ninety One calculations, 30 September 2010 to 30 September 2020, Asian USD Corporate Bond = JPM Asia Credit Index; Asian Local Sovereign Bond = JPM JADE Broad - Asia Diversified Broad Index Unhedged USD; China Onshore Sovereign Bond = Bloomberg Barclays China Treasury + Policy Index, Global High Yield Bond = ICE BofAML Global High Yield Bond USD, Global Aggregate Bond = Bloomberg Barclays Global Aggregate Index, beta and down capture vs. MSCI AC World NR. The above illustration is purely for information purpose and should not be construed as an official/comprehensive performance comparison.

Asian credit is under-owned, providing attractive opportunities

The underweight positioning that global asset owners currently have in Asian credit provides attractive investment opportunities, in our view. There are three broad factors we believe will continue to drive growth:

  1. The economic dynamics associated with a region comprising half the world’s population continuing to increase its proportion of the economic value chain
  2. The potential for the asset class to deliver both attractive annualised returns and also a very low realised volatility, recently evidenced by the smoother and less extreme drawdown than equities during the initial COVID-19 risk-asset sell-off
  3. The diversification benefits of a broad asset class embracing US-dollar credit, local sovereign bonds and local currency bonds, resulting in a low correlation to equities with a positive downside capture

Growth prospects and the postcode premium

Investors will recognise the logos of both companies below as leading real estate landlords in their respective markets, Hong Kong/China and the US. Rental income is comparable, but there the similarity fades. Sun Hung Kai (SHK) generates double the return on invested capital of Prologis, with half the leverage, a slightly higher rating and a higher yield. Comparing their spreads against the US 10-year US Treasury, that for SHK is almost double that for Prologis. This is an example of where investors are being better compensated for the perceived risks of investing in Asian EM, even if SHK’s closer links to China will underpin the growth of its portfolio and earnings.


Figure 4. Higher spreads but superior fundamentals

 
Market position Largest integrated developer / landlord in its home market Leading logistics landlord in its home market
Rental footprint Office: 10m sq. ft. office
Retail: 12m sq. ft. retail
963m sq. ft.
Average rent Office: $86 sq. ft. / year
Retail: $107 sq. ft. / year
$6 sq. ft. / year
Rental income $2.6 bn $2.8 bn
Return on invested capital 6.15% 3.03%
Net Leverage 2.26x (June 2020) 5.07x (Dec 2019)
Rating A1/A+/NR A3/A-/A-
10yr credit spread to US-T 151 84
10yr bond yield 2.23% 1.55%

Source: Ninety One as at September 2020

Asian US dollar credit has defensive qualities, issuers are ‘national champions’

A high proportion of issuers of Asian US-dollar credit are names unfamiliar in equity markets because they are not listed entities. Approximately 35% of issuers are from the sovereign and quasi-sovereign space and this proportion continues to grow. In many cases, issuers of US-dollar credit can be considered ‘national champions’, in the sense that they are controlled by host governments or host countries, and so provide unique investment opportunities not accessible through equities. Companies in the Asian US-dollar credit space are more likely to be issuers able to meet their US-dollar revenues and financing needs. Again, these are likely to be more defensive companies, such as regional utilities or multinationals.

This can also be evidenced by examining leverage, which is a key credit metric. Both on a DM vs EM basis, but also across EM, Asian credit instruments have been some of the least leveraged and the highest quality in the overall credit universe over the past decade.

Consistently lower levels of leverage across Asia

Figure 5. Investment grade net leverage

Investment grade net leverage

Figure 6. High yield net leverage

High yield net leverage

Figure 7. EM net leverage by region

EM net leverage by region

Source: JP Morgan as at June 2020

More recently, while Asian credit has not been able to escape COVID-instigated volatility, its performance over the year has been reassuring, with standout performances by both Chinese bonds and US-dollar credit since the lows in March 2020. Yet these returns have not been accompanied by a heightened risk profile for investors, rather the reverse.

Figure 8. Limited Asian drawdown and stronger recovery post-COVID

Limited Asian drawdown and stronger recovery post-COVID

Source: Ninety One, Bloomberg as at September 2020

Spotlight on China credit

The size of China’s financial markets and the adjustments underway provide investors with enticing exposure to an asset class delivering a diversified source of potential return and a yield premium over major developed markets.

Investors are severely underweight China bonds

Figure 9. Size and composition of the world’s most major bond markets

Size and composition of the world’s most major bond markets

Source: Bank for International Settlements, 31 March 2020.

Over the past five years there has been noticeably greater accessibility for overseas credit investors into China. In September 2020, index provider FTSE Russell confirmed it was including China bonds in its World Government Bond Index. This is expected to inject cUS$120 billion of passive investment into the country over the next 2-3 years alone, with an eventual weighting similar to that of German bunds.

By the final quarter of 2021, therefore, all the major bond indices will have China as a significant component, and it is worth making the distinction between China’s more headline-grabbing equity market and the staider bond market. While the former may be about price targets and earnings beats, China fixed income is all about balance-sheet strength, which is underpinned by China’s position as the world’s largest creditor.

Figure 10. China: investment-grade assets with higher diversifying yield

China: investment-grade assets with higher diversifying yield

Source: Ninety One as at 30 September 2020. USD Bonds: Bloomberg Barclays Global Aggregate United States Dollar TR Index.

No comment on China is complete without highlighting the scalability attractions1 of the market – that the domestic bond market could increase in value to US$35 trillion by 2030, that foreigners only own 2% of the onshore Chinese bond market vs. an equivalent 18-60% in most developed markets, and that only 6% of Chinese household financial assets is invested in mutual funds.

An EM or regional allocation might direct 1% exposure to China credit, which we would argue is too low. On a GDP-weighted measure, we argue this figure should be closer to 20%, allowing for a meaningful impact on returns without increasing overall volatility.



Specific risks

Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.

All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.

Authored by

Wilfred Wee
Portfolio Manager
Alan Siow
Portfolio Manager

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