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Raja Mukherji, Ronie Ganguly
Asian credit markets have seen extraordinary growth over the past five years, but they face headwinds on several fronts as well. It is important for
investors to identify the broad secular themes in Asian credit that drive new supply, default trends, liquidity premia and long-term investment
State-owned enterprises: varying capital discipline, potential restructuringMany state-owned enterprises (SOEs) in China and Korea are working to delever balance sheets and optimize cash flow. In March 2014, CNPC, China’s largest
oil producer, reported a 10% year-over-year decrease in total capital expenditures in 2013 and plans for another 7% cut in 2014. Similarly, Sinopec is
proposing to divest up to a 30% minority stake in its marketing segment.
China also laid out its latest SOE reform plan in late 2013, aiming to improve management and allow the private sector to participate in areas that SOEs
previously monopolized. While we believe this restructuring initiative is a long-term positive, there could be short-term pains. For example, the
liberalization of water and natural gas prices would likely benefit the SOEs operating in those sectors, while deregulation in telecom and banking could
bring more competitive pressure to the incumbent SOEs.
Korean SOEs, under a government mandate, aim to slow their overseas M&A activities and keep leverage in check. For instance, Korea National Oil is
focusing on organic growth, Korea Resources looks to optimize its portfolio of mining holdings and KT Corp is lowering capital expenditures (see Figure 1).
These trends will likely affect net supply in the USD offshore bond market, with North Asia supply largely driven by refinancing and South Asia supply
largely driven by capex. Overall, our bottom-up analysis continues to favor SOEs with high strategic importance, favorable industry trends and sound
Default trends in China onshore credit marketAfter a decade of rapid growth (see Figure 2), China’s bond market – at 30 trillion CNY (roughly 5 trillion USD) – is now the third-largest after the U.S.
and Japan. Even more dramatically, credit bonds (i.e., bonds with default risks, such as corporate bonds and state enterprise bonds) constituted 49% of new
issuance in 2013, up from just 2% in 2000.
In the event of default, offshore investors holding USD-denominated bonds issued by Chinese onshore companies should analyze the regulatory hurdles (court
and regulatory systems, repatriation procedures) and corporate controls (gaining control of and divesting assets). Offshore bond investors face potentially
very low recovery rates, and therefore need to be appropriately compensated for the risk. Bottom-up analysis is key.
Clean energy demandWith pollution now a widespread concern in China, promoting cleaner and more efficient energy is a high priority for the government, which intends to raise
the share of natural gas in the primary energy mix from 5% in 2012 to over 8% in 2020. (Currently, coal makes up approximately 70% of the mix.) Natural gas
is already competitively priced relative to liquid fuels and electricity, and local governments are beginning to promote the coal-to-gas switch. For
instance, Beijing aims to shut down all coal-fired power plants and build four natural-gas-fueled thermoelectricity centers by 2017. Also, China’s recent
gas purchase agreement with Russia should help satisfy China’s growing gas demand. Overall, we expect this trend to benefit global producers who can export
gas economically to China (where demand already outpaces production – see Figure 3) along with select upstream SOEs.
Bank capital: details matterBasel III Tier 2 (B3T2) bonds are still a relatively young and fast-growing asset class in Asia and are increasingly turning to the dollar-denominated
market (see Figure 4). Asian B3T2 structures are generally vanilla and consistent with Basel III standards, with contractual PONV (point of non-viability
definitions, i.e., mostly full or partial principal write-offs). This is unlike many jurisdictions in the West that have resolution regimes and where loss
absorption can be taken based on statutory PONV.
New issue trends: bigger supply, new investorsAsian credit supply remains on track for another record year in 2014, with potential to reach nearly 150 billion USD at its current pace. Total market size
could hit 1 trillion USD in the next three years. China alone accounts for over 50% of new issues. Despite some supply fatigue (meaning wider new issue
premia for new deals), the fundamental backdrop remains very constructive for Asia and we expect issuers will continue to advance any refinancing and
The key driver of growth has been disintermediation of the loan market, which is supported by increased demand from a wider investor base. Global
(especially U.S.) accounts remain underinvested in Asia, and many are looking to add exposure. The local investor base – especially insurance, pension
funds and sovereign wealth funds – is also increasingly participating in new issues.
The pattern of issuance is adapting to the demands of these investor bases. Firstly, we see increasing investment grade (IG) issuance YTD relative to high
yield (HY), although IG spreads are at their tightest in five years (see Figure 5) – yet they remain above their five-year average versus U.S. IG spreads
(see Figure 6). HY spreads, meanwhile, remain far from five-year tights. Secondly, we see a trend toward high quality shorter-tenor floating-rate notes, a
segment strongly supported by U.S. investors, and perpetual bonds, a yield-focused sector supported by retail investors. Thirdly, while there is continuous
growth of first time issuers, their percentage within overall issuance has dropped, possibly as the changing investor base leans toward repeat issuers.
Finally, currency trends support issuers who want to diversify investor bases.
Investment implicationsAt PIMCO, we anchor our investments along these major credit themes, focusing on bottom-up research and careful risk assessments informed by thoughtful
macroeconomic perspectives. In 2014, our views have us targeting select opportunities in state-owned enterprises in energy and utility sectors, investment
grade new issues and B3T2 bonds.
The authors wish to thank Taosha Wang, Yishan Cao, Takanori Miyoshi and Abhijeet Neogy for their contributions to this article.
A word about risk:
Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The
value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more
sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment
increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond
investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities
may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported
by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and
will fluctuate in value. All investments contain risk and may lose value.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee
that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to
invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for
informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment
product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be
reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are
trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United
States and throughout the world. ©2014, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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