Asian Credit: Stabilizing but beware risk pockets

Key points

  • Asian credit rebounded strongly in 2019, evenly balanced between Investment Grade and High Yield
  • We expect the trend of slowing - and low - economic growth will continue in 2020, but a US/China trade deal could change the pattern for the better
  • We head into 2020 with much tighter valuations - but the spread level between Investment Grade and High Yield is still attractive

 

Investment grade credit and high yield rebound

Asian credit is on track to deliver a year of double-digit returns for 2019. The returns were partly driven by a strong rally in US treasury yields, as well as significant spread compression, thanks to a more positive trade war outlook and China’s determination in policy support. As of December 2019, credit spreads have tightened over 40 basis points (bps) for Asian investment grade (IG) credit and more than 60bps for Asian high yield (HY). The key outperformers are investment grade sovereigns - given their sensitivity to US rates - and China property (both investment grade and high yield).

Valuations still attractive, especially for High Yield

Asian credit remains attractive despite the spread tightening, particularly for HY. Currently, the asset class provide over 150bps pick-up versus US HY (and over 300bps for China HY). (Figure 1) The spread differential between BB and single-B credit has also widened to almost 300bps. Given some signs of improvement in China’s onshore credit conditions and the manageable offshore supply going forward, we are positive about increasing high-yield exposure where we have high fundamental conviction.

Figure 1: Asian HY vs. US HY

For Asian IG, we expect spreads to range-bound despite the current tight level. (Figure 2) Domestic demand for Asian IG remains strongly underpinned by solid fundamentals and decent inflows.

Figure 2: Asian IG vs. US IG

2020’s key drivers: High Yield looks solid

After a strong 2019, we think that 2020 will be more challenging, considering the tighter spread levels, lower absolute yields and expectations of slower global economic growth. In addition, a lot of the trade war optimism has already been priced in. As such, we expect more volatility for the Asian credit market in 2020.

Fundamentally, the macro backdrop is still supportive for Asian credit, given the loose interest rate policies of global and Asian central banks. At the same time, investor sentiment is generally stable and more poised to trade-war headline surprises. We also note that the supply pipeline should taper from near record levels while high 2020 maturities will further lower net supply. Thanks to Asian credit’s lower volatility and attractive valuation, we expect fund inflows to be strong in 2020 and the new supply to be well absorbed. If this view holds, volatility in the market would bring forth more trading opportunities, especially in HY.

Forecast and Positioning

As we expect next year’s returns to be mainly driven by carry and modest spread tightening, we still favour single-B credit given the attractive yield level, albeit shorter-dated. Within the single-B cohort, high yield China property developers offer both carry and a total-return opportunity as companies execute on deleveraging to actively improve their credit profiles. While credit fundamentals should remain healthy overall, we foresee pocket of weakness which may cause an uptick in defaults and volatility. In our view, caution remains warranted in certain sectors, including China high-yield industrials, Local Government Financing Vehicles (LGFVs) of Indian financials and Hong Kong property.