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Robert Mead, Raja Mukherji
The last several years have seen some extraordinary growth in the Asian credit markets, and ongoing trends – supply and demand dynamics, banking sector deleveraging, increasing demand for energy across the region, among others – paint a vivid picture for credit investment opportunities over the secular horizon. That said, the potential for volatility, as seen in recent months, along with uncertainties in the global economy underscore the importance of careful research when investing in the robust market in Asian credit.
Rapid expansion across Asia’s credit markets By two key measures – market capitalization and number of issues – U.S.-dollar-denominated Asian credit, including corporates, sovereigns and quasi-sovereigns, has more than doubled in just five years (see Figure 1). We see three main reasons for the dramatic growth in issuance – and, critically, despite recent market volatility, we expect all three to remain in force over the secular horizon. First, there is a lack of U.S.-dollar-denominated sovereign supply as countries develop, mature and increasingly prefer to issue debt in their own currencies. Second, we expect continued strong demand for spread product as net issuance globally remains at fractions of pre-crisis levels. Finally, post-crisis deleveraging within the banking sector has companies looking outside their traditional banking relationships for financing – and to satisfy their growing appetite for mergers and acquisitions overseas.
Indeed, these three factors have opened a huge window for Asian corporate issuers to come to the market for financing, whether to pursue long-term business plans or to employ traditional corporate finance and leverage strategies. The number of countries and range of issuer types in the representative J.P. Morgan Asia Credit Index (JACI) continues to broaden, even as the composition shifts. For example, Korea (including its quasi-sovereign Korea Development Bank) was for many years the single-largest issuer by country in the JACI, but as of February 2013, China has taken its place (see Figure 2), driven by strong corporate issuance. Over the secular horizon, we expect the larger economies in the region – particularly China, India and Indonesia – to continue to increase their presence in the JACI index.
Sectors to watch: energy, financials, high yield, local currency Energy self-sufficiency has almost unanimously declined across Asia in the last decade, and the region’s energy appetite can only expand over the secular horizon as these economies continue to develop and standards of living rise. To meet increasing demand, many Asian oil and gas companies have not only become frequent buyers of foreign assets, they have also regularly tapped the international capital markets to meet their financing needs. Credit investors may find numerous opportunities among high quality energy companies with strong state support, solid fundamentals and a constructive outlook.
In the financial sector, we expect to see continued issuance of dollar-denominated bonds in several countries. Korea, for example, issues mainly for refinancing purposes, while Indian banks want to fund overseas expansion.
The swift emergence of high yield corporate issuers in Asia over the past several years came from a confluence of factors: rapid GDP expansion, broad political stability, an underdeveloped infrastructure, a move toward privatization and a growing need for funding flexibility. This year to date has set a record in new high yield issuance with 76 new issues totaling over $30.4 billion – and the new deals are oversubscribed by an average of 10 times (source: Citi and Bloomberg as of 15 August 2013).
Within the high yield portion of the JACI index, the largest component – and one of the most volatile – is China’s real estate sector. With the given long-term trends toward urbanization and people’s desire to hold property as a financial investment, we expect this sector to continue to grow and consolidate over the coming years despite the rising costs and intensified competition. Policymakers need to tread a fine line between reining in rising home prices and sustaining the sector’s contribution to the overall economy. Therefore the supply pipeline, especially refinancing needs from existing issuers, should remain strong.
China’s retail and consumer sectors are also issuing more in 2013, driven by organic expansion, balance sheet management and domestic and foreign acquisitions. We expect more issuers to come to market over the secular horizon, thanks to growth in personal income and consumption power along with urbanization. Across the real estate, retail and consumer sectors, assessment of the macroeconomic environment together with diligent research is critical. Investors need adequate compensation for execution and default risks.
Asia’s local currency corporate credit markets are developing, but credits currently accessible to international investors – such as Chinese-yuan-denominated “dim sum” bonds – are few. We expect further development in this market and other local credit markets over the longer term, though over the next five years, dollar-denominated credit markets will likely experience the bulk of issuance.
Secular trends in credit quality and risk Sovereign credit ratings have moved generally upward across Asia in the last five years (see Figure 3), in notable contrast to trends in most of the developed world. During the same period, the average S&P rating of the broad JACI index has gradually decreased (see Figure 4), primarily due to the increase in corporate issuance, which tends to be lower-rated. The index average remains investment grade at BBB+. Over the next several years we expect corporate issuance and a wider spectrum of corporate issuers to continue to drive index growth.
Asian corporate bond spreads have been consistently higher than comparably rated U.S. corporate spreads during the past several years (Figure 5 shows two examples), likely due in large part to higher sovereign spreads embedded in Asian corporate bond spreads. Over the secular horizon, we expect this gap to narrow as markets continue to revalue Asian sovereign risk to reflect stronger balance sheets and economic growth prospects.
Another credit indicator to watch in the coming years is debt ratio, which can help uncover value in corporate bonds. One example of debt ratio is the “single turn of leverage,” the one-to-one ratio between debt and EBITDA (one-year earnings before interest, taxes, depreciation and amortization). Currently, most corporate bonds from Asia have higher spreads (over comparable maturity U.S. swaps) per turn of net leverage compared to corporate bonds from the U.S. (see Figure 6). This will likely remain the case over the secular horizon, but we expect the gap to continue to narrow.
Many countries across Asia are also improving the quality of their institutional frameworks, regulatory bodies and bankruptcy regimes. That said, over the secular horizon we fully expect to see instances where these frameworks, bodies and regimes will be tested – challenges which, in turn, may help Asia’s credit markets evolve and develop further. Among issues in the JACI index, over the next two years the refinancing needs across the region are minimal, hence default rates will likely remain low. In 2016–2018, 35% of debt in the index matures and this could be a period with heavier refinancing risk. And over the secular horizon and beyond, we do expect some volatility from increased cash or price defaults.
Investor implications: research and relationships are critical Given that potential for volatility along with weakness in the global macroeconomic environment, good credit research, flexible resources, experienced local portfolio management and strong relationships with local stakeholders are all crucial to uncovering attractive opportunities in Asia’s credit markets.
At PIMCO, our beliefs in the resilience of many emerging Asian countries and vibrancy of credit markets in Asia have us evaluating attractive opportunities in high quality corporate credits. We scrutinize the bond structure to gauge the degree of sovereign shareholder support, and rely on rigorous bottom-up credit research to assess risks and identify best candidates within each sector. We expect the next several years will present many intriguing opportunities in Asia’s expanding, evolving credit markets.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk; investments may be worth more or less than the original cost when redeemed. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. 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. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. 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 long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
The J.P. Morgan Asia Credit Index (JACI) tracks total return performance of the Asia fixed-rate dollar bond market. JACI is a market cap-weighted index comprising sovereign, quasi-sovereign and corporate bonds and it is partitioned by country, sector and credit rating. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO 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. ©2013, 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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