Source: Fidelity International, as at 31 August 2020.
The Case for Asian Bonds
Why adding Asia to your investment-grade portfolio may improve diversification and enhance returns
Asia is increasingly dominant in the global economy. This trend is not new and has been apparent for some time. Currently, the region contributes about a third to global GDP, which is already impressive, but around half to GDP growth, which means the trend is still going strong. In fact, it has likely been accelerated by the often-better handling of the COVID-19 crisis in Asia, and we can look forward to increasing contributions. Nevertheless, fixed income investors in the West still tend to be underinvested in Asia, effectively underweighting the arguably most dynamic region of the global economy. This has much to do with Asia's underrepresentation in the global fixed income indices that function as benchmarks for European institutional investors. On the flip side, the US constitutes a perhaps over-large share of portfolios, as is also reflected in the indices. In this Perspective, we want to argue in favour of taking this imbalance seriously, and to explore what shifting towards a higher weighting in Asian investment grade (IG) might mean. In order to do this, we:
- describe the stable fundamentals in Asian IG, particularly in contrast to US
- take a look at the attractive valuations of Asian fixed income
- give our market outlook for Asian IG
- examine what concrete advantages an investor might expect from a shift towards Asian IG
Currently, Asia is in fundamentally better shape than regions like the US and Europe. This holds true on the sovereign as well as corporate levels, with both contributing to an overall healthier environment for fixed income investments.
China, the dominant regional economy and market leader in Asian bond issuance, has handled COVID-19 reasonably well and is on track to a relatively expedient recovery in economic activity. This is shown by Fidelity's proprietary GEARs indicator (Gauges of Economic Activity in Real time) as of August 2020, where China is further along in the economic recovery compared to the US and Europe. Meanwhile in the US, while we also see a recent rebound in economic activity, we still have to wait for the impact of the tapering of unemployment benefits over the coming months.
Furthermore, a number of factors give Asian central banks and governments more room for monetary and fiscal measures.
- A combination of low Asian inflation and a dovish US Federal Reserve gives ample room for easing.
- Many Asia countries which carry high credit ratings have relatively strong financial buffers allow for large stimulus packages.
- Overall sovereign debt levels for emerging Asia are below 60% of GDP versus more than 100% for the developed world, and external debt ratios are less than half of those of other emerging regions, increasing policy manoeuvrability.
- In contrast, base rates are already close to zero or in negative territory in some developed economies, significantly reducing their flexibility.
This backdrop provides a robust base for the solid fundamentals of Asian IG corporates. Consequently, we expect Asia IG corporates to remain largely stable. Over the years, these corporates have built up some buffer as Net Debt / EBITDA has trended down and overall liquidity has remained constant. Again, this is in contrast to many US IG corporates, which is in a weaker position due to gross leverage trending up and intensifying liquidity pressure.
Moderate fallen angels risk in Asia
The risk of Asian IG paper slipping into high-yield (HY) territory seems manageable. There are around 100 issuers in Asia IG rated BBB- by at least one of the rating agencies, but we only see less than 10 issuers as being materially at risk of falling to HY in our base case. These issuers range from gaming and real estate construction to metals & mining.
Moreover, credit selection is critical in avoiding fallen angels, especially if we see further deterioration in Asia macro conditions, changes in company management or downgrades to sovereign ratings. For state-owned corporates and banks, we would also need to pay attention to their sovereign ratings, also for India and Indonesia, given how closely the rating for such issuers is linked to the respective sovereign ratings.
Our active approach is well-suited to avoiding these risks.
The fundamentals have spoken for the attractiveness of Asian IG for some time now. Recent circumstances such as the COVID-19 response as well as the fiscal and monetary freedom enjoyed by many policy makers in Asia have widened the gap – which makes this a particularly auspicious time to rebalance a portfolio in favour of Asian IG, or at the very least to bring a fixed income portfolio into closer alignment with the relative weights of these regions in the world economy.
However, our case does not stop at fundamentals, and the second big argument concerns valuation.
Asset valuations generally jumped around and attained abnormal and unsustainable levels during the nadir of the COVID-19-crisis in March. Asia IG valuations were no exception. And although they have recovered significantly since the end of March, they remain relatively attractive. Asian IG spreads are still 30% to 40% wider than before the selloff, and the asset class continues to offer attractive yield pick-up compared to peers in the US and Europe. The absolute spread level is still at around 40 basis points (bps) above US IG, roughly double the historical average difference of around 20 bps. As there is ample liquidity in the markets and we remain in a low-yield environment, the hunt for yield will continue, and this will benefit Asian IG.
Investment grade spreads across regions
Source: Fidelity International, ICE BofAML Bond Indices: ADIG for Asia IG, ER00 for Europe IG, C0A0 for US IG, as at 31 August 2020.
Characteristics of Investment Grade Markets
Source: Fidelity International, ICE BofAML Bond Indices: ADIG for Asia IG, ER00 for Europe IG, C0A0 for US IG, as at 31 December 2020. Yield reflects effective yield. Effective yield is the yield of a bond which has its coupons reinvested after payment has been received by the bondholder. It is the total yield an investor receives in relation to the coupon (nominal yield) of a bond. It takes into account the power of compounding on investment returns, while coupon (nominal yield) does not.
Distinctive features of the Asian fixed income market favour diversification and solid demand
- The Asian IG universe includes sovereign, quasi-sovereign and corporates from many different countries. Investors not only gain exposure to fast-growing economies but benefit from diversification exposure. (In contrast, the US IG market is subject to a single country risk.)
- Around 25% of the market consists of sovereign and quasi-sovereign paper. Many state-owned enterprises (SOEs) in Asia enjoy strong links to the respective governments, which supports the overall credit profile of these companies.
- Around 70% to 80% of Asia IG new issues are snapped up by local investors who are subject to strong home-country bias. Consequently, money is stickier, which anchors the overall demand of the asset class and reduces volatility. This effect compensates for US IG's more diversified investor base.
Asia IG country breakdown
Asia IG sector breakdown
Source: Fidelity International, Bloomberg, ADIG index, as at 30 June 2020.
Asia IG market outlook
We would never advocate complacency at this stage and expect some level of market volatility, given all the uncertainties around COVID-19, general political noise, and the US election. And yet, the generally constructive view on Asia IG remains intact for several reasons.
- The unprecedented liquidity tsunami and prolonged low rate environment create a favourable backdrop for the Asian bond market, as this liquidity needs to find a home.
- Central banks and governments are likely to err on the side of over-delivering economic support, both in terms of duration and magnitude, hence reducing risk of a very negative left-tail scenario.
- Asian countries, in particular China, should be the first to emerge from the virus outbreak and will continue to take swift and active measures to support their economies.
- A lot of these countries enjoy a relatively strong financial buffer – e.g. China, Indonesia and Singapore – and have the capability to push out large stimulus packages to support a faster economic recovery.
- Low oil prices are an under-appreciated catalyst for the Asian IG market. As Asia is a net energy importer, this is hugely beneficial. The weaker demand due to COVID-19 will offset the benefits in the near term, but lower oil prices will give a boost to the region once people start spending again.
- On the supply side, total supply reached USD165 bn in 1H20, almost on par with 1H19 levels. IG supply continues to boom in 2020, accounting for 70% of new supply in 1H20. While the average issue size has been relatively stable, the number of new issuers has increased in Asia IG as companies are taking advantage of the attractive funding due to low treasury yields.
- The abundant liquidity, the influx of US dollar into Asia and China, and a weaker US dollar are strong tailwinds for Asia IG.
- The combination of high levels of cash holdings among investors and policy rates at zero is likely to keep the search for yield intense across assets.
- Overall, Asia Investment Grade, with its solid credit profile and cushion from better valuation, should provide stability amid market uncertainty. The faster recovery in Asia along with strong investment demand under low yielding environment should bring a good prospect for the asset class longer term.
What does an allocation to Asia USD IG mean for a US corporate portfolio?
USD Asia IG offers a significant yield pick-up compared to the US in the short to medium term (1-6Y). The table shows EUR hedged yields between 80 bps to 123 bps respectively for this time frame.
Source: Fidelity International, Bloomberg, ICE BofA ML, 15 December 2020. Indices used: ADHY (Asia HY), ACIG (Asia IG), EMSD (EM Corp), DGOV (EM Sov), HE00 (EU HY), ER00 (EU IG), UC00 (Aus IG), H0A0 (US HY), C0A0 (US IG). Analysis excludes bonds rated CCC and below. For illustrative purposes only.
Splitting a portfolio in USD to 70% US IG and 30% Asian IG would enhance the expected yield on 10-year excess return over cash by 20 bps versus pure USD exposure, with the correlations of those returns at only 70% and a reduction of the USD duration by almost a year. Considering the wider credit spreads compared to the US, a further spread compression would benefit total returns of Asian IG.
Allocating between US and Asia IG
Example portfolio comparison
|100% US||70% US / 30% Asia|
|Expected 10y excess return over cash||0.9%||1.5%|
|Expected Sharpe ratio||0.16||0.25|
These are estimates, based on our proprietary modelling, for illustrative purposes only. They reflect the views of investment professionals at Fidelity International.
Source: Fidelity International, Bloomberg, ICE BofA ML, 1 September 2020. Yields and durations as of 15 December 2020. This analysis shows the potential impact on portfolio characteristics from switching between US IG and Asia IG (including government bonds). US IG is based on the ICE BofA US Corporate Index; Asia IG is based on ICE BofA Asian Dollar Investment Grade Index. Historic analysis is done based on monthly total returns hedged to EUR for the period December 1996 to June 2020. Frontier chart is based on our forward-looking capital market assumptions (expected return and volatility) as of June 2020. Expected return is excess over cash, 10 year horizon. Yield figures incorporate 3m FX hedge cost.
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.
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.
Bond investments: 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, as interest rates rise the price of a bond will 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. In general, the funds do not offer any guarantee or protection with respect to return, capital preservation, stable net asset value or volatility.
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: This fund invests 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.
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