The Outlook of Asia Credit Market and ESG Investing - Fund Manager Interview
Q: Principal Asset Management (Asia) Investment Management Team
A: Howe Chung Wan, Head of Asian Fixed Income & Portfolio Manager, Principal Global Investors
Q: What is the outlook for Asian credit market for the remaining of this year?
A: In line with global credit markets, Asia credit posted 7 consecutive negative monthly returns in 1H 2022 with the high yield (HY) portion of the market materially underperforming the investment grade (IG) markets. The spread of Asia high yield touched the high level of COVID times in 2020 with ongoing impact of defaults and debt exchanges in China property sector as well as impact of the global risk off sentiment leading to outflows. Non-China space including India and Indonesia high yield fared better with limited negative returns compared to China HY.
Rising default rates in the China property sector, fueled by tight monetary policy, and sector-specific disclosure issues have pushed Asia high yield returns firmly into negative territory. China’s policy stance has shifted to become less restrictive and further property-specific easing in the coming months may be a tailwind for Asia high yield. With recent shifts in the composition of the Asia high yield market, the universe in our view has become better diversified and more balanced for investors.
In our view, despite the recent shifts in the Asia high yield market, the yield/carry opportunity continues to be attractive, and the asset class offers a relatively short duration (important in an environment of rising rates). It’s our belief, that the China high yield issuers that weather the current downturn are more likely to be well-supported in the markets and will provide relative yield upside to investors. While default rates are likely to remain elevated in 2022, we think that a lot of the downside has already been priced into bond prices.
Q: Specifically on China, is it still a good timing to invest in its bond market?
A: With China undergoing a structural rebalancing from investments towards consumption, the domestic economy is becoming a more important driver of asset prices. And, as China’s economy and asset prices have become increasingly uncorrelated with other emerging markets and with the rest of the world, China based investments make a unique investment proposition in a world of increasing volatility. China’s correlations with the rest of the world have fallen recently, likely reflecting structural shifts in the real economy as its focus shifts towards domestic drivers.
The policy divergence between Federal Reserve (Fed) and People’s Bank of China (PBoC) has been fascinating to follow. Whereas the Fed (and many other global central banks) has embarked on a rate hiking cycle to remove the over-easy policy utilized during the pandemic, the PBoC, which has been tightening policy since 2020, has room to ease monetary policy to support its economy. China fixed income stands to benefit from this position as it is further utilized as a diversifier and source of relatively higher yield in global fixed income portfolios.
While higher carry and at a point where RMB has adjusted to the interest rates differentials relative to the world, onshore bonds become attractive amid a monetary easing backdrop, credit risk remains high for offshore corporate bonds, presenting opportunities to investors with strong selection skills.
Q:As China’s property crisis deepens, what signals should investors watch to identify turning points in the sector?
A: As we’ve entered 2022, China has started to shift its policy stance to be less restrictive. Despite these recent policy adjustments, a positive impact has yet to meaningfully translate into the performance of the China high yield market; especially, the property sector. China high yield sector continues to face poor sentiment and continued weakness in the high cash bonds in the high-quality space and idiosyncratic stories dominating the space. With fears growing and liquidity crunch among developers, rippling through healthier companies, percentage of China high yield bonds trading closed to distressed levels have increased. Even the names with low expectations of default were traded lower due to liquidity squeeze.
Since the China homebuyers’ mortgage boycott spread out, we have seen central and local authorities are taking measures trying to address this presold units’ delivery delay issue and we don’t expect further tension escalation or a crisis to China’s banking system in the near term. That said, we do see an impact to homebuyer sentiment which will depress home sales activities and the ability of developers to generate cash. Recent moves on further MLF/LPR cuts, onshore bond guarantees on selected POE developers debt as well as special loans catered to support the completion of stalled housing projects are significantly positive actions taken by policymakers. We still need to watch out for this event’s impact on China’s new home sales momentum, other POE developers’ debt repayment or potential policy execution risks in 2H22.
As investors assess the China property sector going forward, there are four key areas where we believe they should be focused:
- 1. Signs of improving property sales especially following the recent reduction in down payments and interest rate cuts
- 2. Improved refinancing onshore indicating sign of bank and bond market support to the sector
- 3. Easing administrative controls over developers’ use of onshore restricted cash
- 4. Improved regime for asset sales enabling better liquidity
As we move further into 2022, markets will be looking for any indication of additional policy rate cuts as well as signs of an end to the regulatory tightening cycle in sectors away from the property sector, such as technology, health care and education. Any further softening of policy, in our view, would be constructive for China high yield and a tailwind for Asia high yield markets overall.
Q:How would our Asian credit portfolios position to capture opportunities?
A: While interest rates in developed markets are on the rise, overall Asia credits still possess potential yield advantages. Benefiting from higher yields and relatively short duration, both Asian investment grade and high yield bonds have yield/duration ratios higher than their global counterparts. This may cushion the impacts of rising interest rates. Despite volatilities and idiosyncratic risk in China high yield space, China investment grade and high yield are trading very differently. The fundamentals of China IG have held up well, backed by strong onshore technical and low correlation in TMT and SOE space compared to the global and US investment grade.
We continue to see the value of the Asia high yield asset class in its lower correlation with the rest of the world in the macro sense especially in China credits; however, weaker fundamentals in China HY and global beta in the rest of the asset class means such lower correlation hasn’t been reflected in recent return. The underperformance of credit relative to equity in the face of a sharp slowdown in growth is particularly jarring, and we believe outflows in the credit space and the impact of lower liquidity have led to credit lagging the markets both on the downside and the upside.
We believe it may still be months away from a turn in Fed tightening stance, property sales and the Chinese real economy respectively. The path of global monetary policy tightening, China property sector recovery, fund flows, and risk appetite will determine Asia high yield returns in the rest of the year.
As we continue to see volatility in the Asia credit market stemming from heightened geopolitical risks, we believe the team and the strategy are positioned well to seek to add value for investors as markets recover. We continue to stay invested in selected non-China sectors such as Indian renewables and Indonesian utilities, while selectively adding top China real estate developers in view of the positive policy momentum.
Q: Will ESG investing take off in China with its ambitious green targets? Can Asian sustainability create alpha opportunities for investors?
A: The government’s action plan for reaching peak carbon emissions by 2030 and carbon neutrality by 2060 means opportunities for investors. In particular, the new energy power generation and new energy vehicle industries should see significant growth. In 2021, the production of new energy vehicles in China was 3.55 million units, up 160% year on-year, and annual sales reached 3.52 million units, up 158% year-on-year.
It is not unreasonable to see this growth continuing, considering that the world's largest power battery enterprise, lithium separator enterprise, electrolyte enterprise, and ternary cathode material enterprise are all in China. As government subsidies promote further investment in the new energy industry, companies that contribute to green initiatives stand to potentially benefit.
The long-term cumulative returns of ESG indices within the region have not outperformed traditional indices within Asian fixed income. This has been one of the hurdles for more investors getting into the Asian ESG credit market. However, from mid-June, we saw a turnaround and ESG investment returns began to outperform or at least has become more in line. One of the main reasons, we believe, is that investors turned to factor in the possibility of a recession in the US, and energy prices retreated as a result. This trend has continued in July.
In the medium and long term, we believe that ESG investing has a strong future in Asian fixed income and is likely to transition into an alpha generation tool, with opportunities coming from potentially rising greenium (negative spread to non-ESG bonds), transition enablers which are pivoting away from non-ESG to ESG, and investments in new ESG sectors such as renewables, battery space, social financing. Besides, there is a strong policy impetus to grow the ESG universe in Asia, coupled with an evolving regulatory landscape that supports ESG growth.
We think as the ESG story evolves and as dedicated ESG assets grow, in our view, the increased flows biasing towards the better ESG performers may lead to increased differentiation between ESG outperformers and underperformers. Already one thing we have seen is some sell side being less willing to trade names with ESG issues meaning a lower liquidity for these names. We have also seen a neighborhood effect whereby an issuer printing a green bond or ESG bond tends to have some benefit of helping the rest of the curve compared to other like for like names.
ESG is also likely to offer good downside protection leading to a lower volatility asset class. A well structured ESG approach should help investors to avoid landmines, hang on to the winners, provide a lower volatility portfolio given the stickier nature of the investor base.
Howe Chung Wan
Head of Asian Fixed Income & Portfolio Manager
Principal Global Investors