Looming headwinds are likely to challenge the Asia credit space during the remaining months of the year, encouraging investors to move up the credit curve.
Deteriorating cash generation, tougher borrowing conditions in addition to already leveraged balance sheets open up a new downside for Asian credit, according to Morgan Stanley in a research note on March 18. This is especially true for the high-yield sector.
“We are cautious and view this as a decompression environment,” said Viktor Hjort, credit analyst at Morgan Stanley, in a telephone conference call on Tuesday. “The environment for global credit is still reasonably benign and better than it is in Asia, and that limits downside, at least for parts of investment grade, but for weaker high-yield corporates, the environment will feel increasingly recessionary.”
Morgan Stanley advises investors to move up in quality into high-rated, long-duration credit, such as financials and Hong Kong corporates. Banks have more stable fundamentals, less pressure to tap bond markets and are less exposed to an expected uptick in default rates, says Hjort.
However, there are potential catalysts that can prove to be supportive for Asian credit, notes the bank. For example, an economic growth recovery in Asia would deleverage balance sheets and make currently wide spreads look attractive.
Spreads are currently hovering around 274bp right now for Asian credit, according to Bloomberg data. Fair value for Asia credit is likely to touch 355bp a year later, estimates Morgan Stanley. But based on the bank’s base case – where it expects sluggish growth to persist but no recession – spreads are likely to widen to 325bp in 12 months.
In the bank’s base case, US GDP remains in the 2.5%-3% range, Asia ex-Japan GDP growth stabilises at 6% while China GDP slows moderately to 7.2%. By year-end, 10-year US Treasury rates will rise modestly to 3.3%.
Other catalysts that could help support Asia credit include the Federal Reserve’s continued engagement in ensuring an orderly decrease of fixed income asset purchases, causing rates to rise in an orderly manner. This alleviates the pressure on higher real rates, says Hjort.
Also, easier credit conditions in China will lead to an improvement in access to bank credit, thereby reducing supply risk in the offshore market especially in the high-yield property space.
If such catalysts were to materialise, a bull case scenario could occur, but the probability of that happening is 20%, notes Morgan Stanley. Spreads are expected to tighten to 250bp a year later with excess returns of 4%.
Risks
On the other hand, looming investment risks could impair the performance of Asian credit.
“[When] substantial Asian or emerging market growth [happens] at a time when corporate balance sheets are highly leveraged, this would leave Asian corporates vulnerable,” said Hjort. “Also, if Fed communicates ineffectively or loses control of the long-end of the Treasury curve and rates rise sharply, this could lead to rising corporate funding costs and capital flight.”
Morgan Stanley’s bear case – which has a 20% probability of occurring – is where a global recession takes place. This is when higher economic growth fails to materialise in the US, Asia ex-Japan GDP slows to a decade low of 5.5% and China GDP growth slows to 7%.
In the bear environment, Asia is also expected to head into a more adverse part of the credit cycle with the worst corporate balance sheets and toughest borrowing conditions than at any time since 2008/2009. In this scenario, Asian credit spreads are likely to hit 550bp a year later and excess returns will be in the negative territory of -11.7%, highlights the bank.
