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Opportunities in Asia Investment Grade

Asia Investment Grade (IG) has faced significant pressure as investors have to juggle the double-whammy of the Fed’s hawkishness and China slowdown. Asia IG index recorded -9% return YTD (as of 9 May 2022) and suffered from its largest drawdown in history. Mark to market volatility of Asia IG has been disappointing for many investors. However, there are good reasons to stay invested in the asset class. While multiple risk factors such as higher rates, China’s economic uncertainty and geopolitical risks are likely to remain roadblocks ahead, this could present a good entry point for investors to capture attractive total return potential with a medium to long term investment horizon.

Chart 1. Asia IG Total Return Index Value

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Source: Fidelity International, Bloomberg, ICE BofA Merrill Lynch Bond Index, as of 9 May 2022. Asia IG Index is represented by ICE BofAML Asian Dollar Investment Grade Index (ADIG Index).

1. Fundamentals: Asia IG corporate fundamentals remain solid. Asia inflation risk is manageable. More China easing should boost market sentiments. 

a) The significant mark to market drop of Asia IG has not been a result of fundamental impairment. Despite challenging macro backdrop, Asia IG corporate fundamentals remain resilient with healthy interest coverage and adequate liquidity.  Additionally, IG credit ratings are seeing net upgrades since 1Q 2021. Corporate fundamentals remain key driver to asset class recovery should we see macro backdrop turns more favourable.

Chart 2. Asia IG corporate: EBITDA/Interest Expense has improved

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Source: Fidelity International, Bloomberg, J.P. Morgan, as of December 2021.

Chart 3. Asia IG corporate: Liquidity remains adequate with cash at over 35% of total assets

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Source: Fidelity International, Bloomberg, J.P. Morgan, as of December 2021.

Chart 4. Asia IG ratings have turned positive again since 1Q21

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Source: Fidelity International, J.P. Morgan, as of March 2022.

b) Manageable inflation risk in Asia

We believe Asia countries are in better shape to control inflation risk compared to the West, with some divergence across countries.

Firstly, supply chains are less distorted given many Asian countries are self-sufficient with raw materials. They mostly benefit from proximity to resource and other part of the supply chains which limit supply chain disruptions. For example, India imports critical commodities for infrastructure and capital goods mainly from ASEAN countries.

Second, due to stricter COVID-19 policies in Asia in early days, demand push is more gradual compared to the West who already enjoyed the consumer boost from the unprecedented stimulus.

Finally, Asia governments have other measures to control inflation such as price control executed by state-owned enterprises.  For example, Indonesia recently bans exports of cooking oil and its base materials to secure domestic supply and better control domestic price for economic recovery.

c) China easing and pivoting away from zero covid policy are on the horizon

China sets a gross GDP target of 5.5% in 2022 but the omicron wave and consequential strict lockdown measures in cities weigh on the economy. It is worth noting that China has always been serious about its GDP target once set since implementation in 1994 (with the biggest missed target at -0.5% in 2019) and there has been no precedent for China to change annual GDP target in history.

Additionally, this year is a significant political year for the Chinese authority, where the Communist Party of China (CPC) will hold the 20th party’s congress in October (once every 5 years). We believe more top-down stimulus measures are needed, not only for the authority to guard against multiple headwinds such as slower growth and employment pressure, but also for an important political agenda for the country to shine in a tightening world.

We also think China will pivot away from zero covid policy to ensure economic and social stability, which will be a huge positive for consumption recovery.

2. Valuations: Asia IG valuations look increasingly attractive

Investment grade bonds have to contend with rising UST yields. However, instead of seeing credit spreads to tighten as they normally behave in a rising environment, Asia IG credit spreads widened in recent months amid concerns over China’s economic growth and heightened geopolitical tension.

Chart 5. JACI Investment Grade Total Return

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Past performance is not a reliable indicator of future returns.
Source: Fidelity International, Bloomberg, J.P. Morgan, as of 9 May 2022. Spread Return is represented by JACIIGSR Index; UST Return is represented by JACIIGTS Index; Total Return is represented by JACIIGTR Index. Returns above include carry.

We think that the risk of the asset class to get hit significantly further from here is contained. Overall, the mark to market drop was not driven by credit impairment fundamentally. The headwinds on Asia IG are likely to abate in the medium to long term.

On rates, UST 10-year yield has increased by 150bps YTD and reached 3%. While we think there is still some room for UST yields to go higher i.e., another 25-50bps depending on market conditions, the magnitude and aggressiveness for rates to move materially higher are unlikely. Market has priced in most of the tightening measures with an expectation of 9-10 hikes by end of this year, but we are more dovish than consensus especially significant tightening in financial conditions and associated growth concerns will likely prevent it from hiking in line with current market pricing and consensus.

Meanwhile, Asia IG spreads have widened by 30% YTD and reached a more reasonable level. Specifically, China IG spreads offer more attractive spread pick up in both absolute and relative terms. We see attractive risk reward in selective high quality China IG names including quasi sovereign, property, and TMT, supported by solid credit fundamentals and expectation of China easing. However, downside risk from slower economic growth amid rising COVID cases and zero covid policy could continue to weigh on sentiments in the near term.

Chart 6. Investment grade spreads across regions

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Past performance is not a reliable indicator of future results. 
Source: Fidelity International, ICE BofAML Bond Indices: ADIG for Asia IG, ER00 for Europe IG, C0A0 for US IG, as of 30 April 2022. 

3. Technicals: Market sentiments remain fragile. Lower net supply is positive. ESG-labelled bonds shift to domestic issuance.

Market sentiments are likely to remain under pressure in the near term with market uncertainties and rising rates environment. 
On the other hand, supply picture is positive for technicals, Asia IG net supply is expected to decrease YoY due to less opportunistic issuances amid rising rates environment and diminishing cost advantage for Chinese companies to issue offshore bonds. There is also a shift for ESG-labelled bonds to domestic issuance notably in China, Philippines, and Korea. Government support remains the critical growth driver for ESG-related issuance to flourish.

The sharp correction in Asia IG YTD has brought valuations to more reasonable levels. Meanwhile, because of its shorter duration and strong local investor base, Asia IG appears to be more resilient than US IG and other EM regions. China offshore IG bonds have also become more attractive to onshore investors, with China onshore bond yields having trended down.

Chart 7. China onshore AAA bonds trade at lower yield than offshore

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Source: Fidelity International, WIND, J.P. Morgan, as of 30 April 2022. 

Fidelity's capabilities and offering

If you believe that your portfolio could benefit from a higher Asian IG allocation – or just want to find out what effect it might have — you have come to the right place. We are to our core a research-driven and active manager across all regions and asset classes. Asian IG comprises issuers from many countries and sectors, and as such is a diverse and multifaceted asset class that lends itself particularly well to this approach.

Asia is a rapidly developing market but far from being developed, which demands full involvement and focus from investors and participants. As such, Fidelity’s Asian Fixed Income team was set up in 2002, based in Hong Kong, with Asian focus strategies since 2007.

The depth of our research resources enhances our ability to generate performance through all phases of the market cycle. Fidelity has one of the biggest Asian credit research teams in the region based in Hong Kong, Shanghai and Tokyo, covering most of the Asia bond universe, in addition to our team members in London. Our investment team’s presence in China further provides dedicated expertise on the ground from fundamental and relative valuation due diligence to idea generation, surveillance and execution.

Our commitment to global and regional research cannot be understated given the rapid evolution of Asia bond market, the sharp increase in new issuers, and our ability to identify cross-market opportunities. Moreover, there are additional investment professionals based in Delhi (India) and Dalian (China) that support these analysts in research process.

In addition to our capabilities of working with you to find the best possible solution given your existing holdings and preferences, we also offer a number of mutual funds in this space, which distil our know-how and expertise into comprehensive solutions. These funds include:
 

  • Fidelity Funds — Asian Bond Fund
    The fund provides a pure yet diversified Asian fixed income exposure, and aims to provide income and capital growth. The goal is to generate attractive risk-adjusted returns through combining multiple, diversified investment positions. The fund predominantly invests in US Dollar-denominated investment grade corporate bonds of Asian domiciled issuers, with at least 70% in investment grade bonds of issuers that have their main business activities in Asia.The fund may take advantage of tactical allocations to Asian local currency markets as a means of generating returns. Emphasis is put on bottom-up issuer selection and ensuring adequate diversity due to the asymmetric nature of corporate bond returns. 
  • Fidelity Funds — China RMB Bond Fund
    The fund aims to provide income and capital growth. The goal is to generate attractive risk-adjusted returns through combining multiple, diversified investment positions - advised by in-house fundamental credit research, quantitative modelling and specialist traders. The fund primarily invests in RMB-denominated corporate bonds, adding money market securities and cash as the situation merits. At least 70% is in investment grade bonds denominated in RMB or investment grade bonds of issuers that have their principal business activities in the Asia Pacific region. The fund is managed according to Fidelity’s active philosophy and approach to fixed income investing.

Risk Warning

The value of investments and the income from them can go down as well as up so you may get back less than you invest.

Past performance is not a reliable indicator of future results.

The funds do not offer any guarantee or protection with respect to return, capital preservation, stable net asset value or volatility.

The funds are classified as article 6 funds according to the Sustainable Finance Disclosure Regulation (SFDR). The funds promote environmental and/or social characteristics. The Investment Manager’s focus on securities of issuers which maintain sustainable characteristics may affect the fund’s investment performances favourably or unfavourably in comparison to similar funds without such focus. The sustainable characteristics of securities may change over time.

Bonds: The funds invest in bonds whose price is influenced by movements in interest rates, changes in the credit rating of bond issuers, and other factors such as inflation and market dynamics. In general, There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity. Default risk may, therefore, vary between different government issuers as well as between different corporate issuers.

Corporate Bonds: Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds.

High Yield Bonds: Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the Fund investing in them.

Overseas Markets: The funds invest in overseas markets and so the value of investments can be affected by changes in currency exchange rates.

Currency Hedging: Currency hedging is used to substantially reduce the risk of losses from unfavourable exchange rate movements on holdings in currencies that differ from the dealing currency. Hedging also has the effect of limiting the potential for currency gains to be made.

Emerging Markets: The funds invest in emerging markets which can be more volatile than other more developed markets.

Derivatives: The funds may use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The funds may make increased and more complicated use of derivatives and this may result in leverage. In such situations performance may rise or fall more than it would have done otherwise. The funds may be exposed to the risk of financial loss if a counterparty used for derivative instruments subsequently defaults.

Others: Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. The investment policy of the funds means it can be more than 35% invested in transferable securities and money market instruments issued or guaranteed by an EEA State, one or more of its local authorities, a third country or a public international body to which one or more EEA States belongs.

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