(ATF) The Asian credit market did not escape the last few months of extreme volatility in financial markets, but compared with its peers it has proved resilient amid the coronavirus pandemic and the signs currently point to a positive medium- to long-term outlook for the asset class in our view.
Within the broader emerging market debt (EMD) universe, US dollar-denominated Asia credit was far more contained during the Covid-19 outbreak – showcasing its defensive qualities within the EMD space.
Asian credit also performed well relative to developed market corporate credit, with Asia investment grade (IG) spreads outperforming US IG corporate spreads during the March sell-off (as noted by JPMorgan and Bloomberg Index Service), reinforcing the case for the strong diversification benefits of our asset class during periods of market stress.
The asset class’ recovery also benefitted from tailwinds unique to Asia Pacific.
First, key economies across the region, namely China and South Korea, were effective in containing coronavirus outbreaks and quicker to resume business activity while other parts of the world lagged.
Also, the region has relatively less exposure to the commodity sector and has avoided the drag caused by the collapse in oil prices. Lastly, there is a strong demand for US dollar Asian credit from the regional buyer base within the Asia Pacific, which meant our asset class did not experience as much panic selling during the market trough.
Having stabilised, the focus of discussion is now on the impact that historic levels of fiscal and monetary stimulus could have on corporate fundamentals and whether this will prevent a wave of defaults in Asia Pacific.
Varied levels of containment success
Thus far, there has been divergence in the macroeconomic fundamentals across the region, with countries displaying varying levels of success in containing the outbreak and differing degrees of economic impact.
Governments continue to strike a balance between managing the healthcare situation and facilitating a return to business activity.
Meanwhile, some policymakers in the region find their ability to provide stimulus packages may be constrained by their individual fiscal capacity and external vulnerabilities. This divergence is being partly reflected in sovereign and corporate credit spreads – for example within the high yield (HY) space, Chinese bonds have outperformed India, Indonesia, and Frontier sovereign credit (JP Morgan Asia Credit Index Diversified).
The onset of the coronavirus pandemic also clearly means that default expectations now need to increase as pullbacks in economic activity will negatively impact corporate earnings. In this environment, it is imperative to focus on bottom-up fundamental analysis to differentiate between the winners and losers. Issuers that have sustainable operations guided by strong Environmental, Social, and Governance (ESG) principles will be better at mitigating risks to their business model, and those that have healthy balance sheets and funding access will be more equipped to avoid financial distress.
Low exposure to challenged sectors
Even so, we expect the Asia HY default rate in 2020 is likely to remain in line with historical levels. Looking at China specifically, policymakers have announced several liquidity-boosting measures so far this year, while continued access to onshore bond markets could reduce the refinancing risk for HY corporates with outstanding USD-denominated issuances. Furthermore, the Asia HY corporate universe has relatively low exposure in industries such as energy, travel, and aviation, where the outlook will remain more challenged and uncertain.
In contrast, we see the China real estate sector as a bright spot within this space, having observed a strong recovery in contracted sales volume in the second quarter and seeing management teams take a proactive approach to liability management since the beginning of the year.
Yields still attractive
The outlook for Asia credit over the medium- and long-term remains positive in our view. We acknowledge the risks that remain evident in the current environment, with uncertainty over the further waves of Covid-19 outbreak across the region and the impact on re-opening economies, as well as heightened tensions between the US and China. Moreover, there has been a strong recovery in asset prices from the bottom in mid-March.
Despite that, yields and credit spreads are still attractive relative to historical levels, particularly against a backdrop of accommodative global central bank policy.
We think that valuations in Asia HY bonds remain compelling and have room to compress and deliver solid total returns.
There remain ample opportunities to achieve solid returns, and we believe that focusing on fundamentals to make country and security selection decisions will be the key to unearthing these.
By Sheldon Chan, Co-Portfolio Manager, Asia Credit Bond Strategy at T. Rowe Price