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 restructuring
Many 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).
By contrast, major SOEs in India, Indonesia and Sri Lanka are increasing leverage, albeit from a low base. ONGC, India’s largest oil and gas upstream
company, recently raised 4.8 billion USD, while Pertamina raised 1.5 billion USD from the offshore debt market to fund its overseas investments.
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 market
After 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.
Performance for China’s enterprise bonds and corporate bonds tends to be rate-driven, making it sometimes difficult to differentiate among credits.
However, recent defaults have highlighted how overall risk profiles of Chinese corporates may be deteriorating as they re-leverage. That said, we believe
the overall impact of defaults on the financial system will be limited at this point, with potential default candidates likely limited to small, mostly
privately owned, companies.
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 demand
With 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.
In India, LNG (liquefied natural gas) import volume expanded significantly in the last few years as domestic production disappointed and demand rose. The
country plans to more than double its total LNG regasification capacity to 55 million tons per year by 2018. The power and fertilizer sectors consume over
half of India’s natural gas, and the high current demand has led to high price elasticity and resistance to further price increases (in April, a proposed
nationwide gas price hike failed to kick in). Overall, the pricing, demand and consumption patterns have us cautious about natural gas as a source of clean
energy in India.
Bank capital: details matter
Basel 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.
Apart from the usual assessments like fundamentals, ratings and technicals, when evaluating B3T2 bonds in Asia, investors need to keep in mind the
qualitative differences in PONV definitions (in Japan and Korea, for example, these are relatively creditor-friendly), government ownership and support,
bank resolution regimes, call economics/extension risks, bond structures and common equity Tier 1 (CET1) write-down triggers. Since there are limited
comparables and pricing precedents in Asia, investors should compare B3T2 bonds with global developed and emerging market banks and adopt a mix of
valuation approaches. At PIMCO, we look at relative value versus global B3T2 bonds while controlling for the above differences. Next, we compare the
spreads with other instruments in the bank’s capital structure. Further, we look at relative value versus similar non-loss-absorbing legacy capital to
check if an investor is being paid the PONV premium. Lastly, if we are investing in callable B3T2 bonds, we assess the call economics/extension risks.
New issue trends: bigger supply, new investors
Asian 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.
High yield themes: tread with caution
The overarching secular theme for Asian high yield is the search for yield. Investors may need to revisit estimated future default rates and recovery
assumptions, which may rely too much on expectations of a “China Government backstop” – note, for example, recent high-profile defaults in the onshore debt
market. Assuming the same recovery rate, Asia IG and HY credits show higher implied default probabilities than U.S. and European credits given historical
spreads (see Figure 7). While the gap between Asia IG and U.S./Europe has largely stayed the same since mid-2013, Asia HY has underperformed with a wider
gap versus U.S./Europe HY as China’s property sector weakened. This combined with overall slowing growth supports our view that spreads still have scope to
widen from current levels. Caution is warranted, and we focus on bottom-up analysis to segregate the winners. We look for strong fundamentals, stable
business models, potential to generate free cash flow and ability to keep leverage in control, especially in periods of liquidity stresses. We prefer
sectors with secular growth outlooks, strategic importance, a sustainable competitive edge and a stable regulatory regime.
At 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.