Manpreet Gill (Standard Chartered Bank)
The Korea Herald is running a regular contribution series written by senior investment strategists at Standard Chartered Group Wealth Management. -- Ed.
Prices of Asian US dollar-denominated corporate bonds have fallen this year. This raises the question: do they now offer attractive value?
The average yield premium offered by the bonds over US Treasury yields (credit spread) looks more attractive than it has been in many years, despite the recent rebound. However, one cannot help but worry if rising defaults could overwhelm the attractive yield, since economic recessions usually tend to be accompanied by a rise in corporate defaults.
To resolve this dilemma, we examine other markets, such as the US, which have a longer history through more economic cycles, compared with the relatively younger Asian USD bond markets. Our assessment leads us to the conclusion that there is indeed value in Asian USD bonds today. While a rise in default rates usually occurs as economies go through a recession, corporate bond markets bottom well before defaults peak. Following the drop in bond prices this year, we believe investors are best placed to take advantage of higher-than-average yield premiums over Treasurys today, rather than be distracted by headlines about high profile defaults.
Short history of Asian USD bonds
The offshore Asian USD bond market is relatively young, notwithstanding its fast growth in recent years. The total market capitalization of the regional benchmark index has risen from just $165 billion in 2006 to over $1 trillion. Default rates in the asset class have generally stayed below 3 percent for most of the current cycle, lower than that for other major emerging markets. About two-thirds of the asset class now comprises investment grade bonds.
Having said that, its relatively short history means it is difficult to draw conclusions on how it could behave through a recessionary default cycle. This is where the perspective of a market like the US, which has a longer history, can help.
Lessons from the US
From a default history perspective, the higher yielding sub-component of the US corporate bond market may be most helpful (this is where most defaults occur in bond markets). Since 1980, the US high yield market has weathered three significant default cycles -- the early 1990s, the early 2000s and 2008-09. During all three, 12-month default rates rose from a range of approximately 1-4 percent outside of recessions to well above 10 percent during or after recessions.
However, for a bond investor, a few characteristics stand out:
-- Actual defaults peaked well after bond markets had bottomed in most cycles. For instance, in the 2008-09 cycle, corporate bond markets bottomed in late 2008 while actual default rates only peaked in mid-2009, when markets were already well into their recovery.
-- Whether equity or high yield bond markets bottom first in a recession remains open to debate. However, in the 2008-09 cycle, high yield bonds bottomed before equity markets.
-- In the 2008-09 crisis, 12-month total returns from US high yield bonds were largest if an investor had added exposure in December 2008. Waiting till mid-2009, closer to when default rates peaked, would have reduced the 12-month total return by two-thirds.
Are Asian USD bonds different?
Of course, Asian USD bonds are different from US corporate bonds in some ways. Through the uptrend over the past decade, the asset class tend to be less volatile than its US or European peers, a track record it has maintained through the most recent sell-off. Asian USD bonds also benefit from a relatively stable base of regional buyers -- for instance, about 70 percent of demand for newly issued bonds are from Asian investors. This arguably makes the asset class less vulnerable to volatility in capital flows into Emerging Markets.
However, concentration of the asset class across geography and sectors are a potential risk. Geographically, the rising share of Chinese companies selling US dollar-denominated bonds in recent years has meant that issuers from China now account for about half the asset class. Asian USD bonds offer a good mix of government/government-owned issuers (about a third) and private sector corporate issuers (about two-thirds). However, the sectoral distribution of private corporates is not as diversified as US bond markets, with about 70 percent of the bonds originating from the top three sectors.
On balance, there are enough similarities with US bond markets that lead us to believe that similar trends will apply, even if the specific levels (for yields or default rates) end up being somewhat different.
So, is there value?
From our assessment above, we conclude that Asian USD bonds offer value at current levels. While absolute yields are lower compared with riskier bond asset classes, we believe the reward for risk taken remains attractive, given their lower volatility relative to US and European peers, their relatively strong regional buyer base and average investment grade credit quality. The historical experience of US corporate bond markets suggests periods of higher-than-usual yield premiums over Treasurys, such as today, can be very good buying opportunities for long-term investors even if defaults rise. Indeed, Asian USD bonds are currently one of our preferred bond asset classes (alongside emerging markets USD government bonds).
Headlines around defaults and debt repayment pressures could rise in the coming months as firms and economies around the region grapple with the impact of COVID-19 and related economic shutdowns. However, from a bond investor’s perspective, the key lesson from history is that it makes sense to add exposure well before defaults (and the accompanying headlines) reach their peak, regardless of how uncomfortable this may feel behaviorally.
By Manpreet Gill
Manpreet Gill is head of fixed income, currency & commodities strategy at Standard Chartered Private Bank. The views reflected in the article are his own. -- Ed.