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:
- The economic dynamics associated with a region comprising half the world’s population continuing to increase its proportion of the economic value chain
- 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
- 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
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
Figure 6. High yield net leverage
Figure 7. 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
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
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
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.
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.