International investors say that higher interest rates in the US are a “bad thing” and a key risk to Asian credit performance during 2014, according to a Morgan Stanley report published on Wednesday. Even so, investors should keep an eye out for windows of opportunity in the region’s fixed income market.
Many market participants are predicting that the US Federal Reserve will start tapering during the first quarter next year, which they say will result in a stronger US dollar and an upward trend in Treasury yields.
Morgan Stanley agrees. The bank says that 10-year yields will touch 3.45% by the end of next year and that Asian credit spreads — based on the JP Morgan Asia Credit Index — will widen during the course of 2014 to 320bp.
A similar spike in rates brought mayhem to credit markets this year, so investors may be tempted to avoid products that underperformed this year. In Asia, that means staying away from long-duration credit and fixed-income instruments from economies with weak external balances, such as India or Indonesia, and instead focusing on shorter-duration bonds.
However, Morgan Stanley says the details matter and differs on what the outlook for rates and currency could mean for credit.
“We think that a combination of a new Fed approach, steeper credit curves and some basic macro improvements makes Asian credit less specifically rate-sensitive than six months ago, and view longer-dated investment grade as an alpha opportunity and feel that Indian credit — SOEs and financials — no longer warrants being underweight, at least not tactically,” said Viktor Hjort, credit analyst at Morgan Stanley.
Part of the reason for this is that the short-end of the curve has become quite crowded and sensitive to the risk of one or two credits turning distressed.
The Fed has also spent a lot of time since the summer emphasising that the decision to unwind its $85 billion-a-month asset purchases is purely technical and separate from the timing of its first rate hike. Assuming investors heed this message, credit spreads should react more benignly than they did this year.
“For the first time in a while, we are witnessing a diverging credit trend where investment grade balance sheets are showing signs of stabilisation even as high-yield balance sheets continue to deteriorate,” said Hjort. “In our view, the sweet spot in Asia credit is to own 10-year investment grade credit.”
Upgrade India credit
India’s balance of payments outlook now looks considerably stronger, primarily due to higher capital inflows through the central bank’s foreign exchange swap windows and controls on gold imports, Morgan Stanley notes.
For example, the South Asian nation has received about $34 billion through FX-related swaps in the form of non-resident Indians’ deposits and overseas borrowing by banks, against Morgan Stanley’s base case estimate of $15 billion. This will result in a stronger capital account surplus — $69 billion versus a September estimate of $58 billion.
The sharp decline in gold imports, as well as export growth surprising on the upside, will lead to a lower current account deficit — $54 billion versus a September estimate of $59 billion, adds the bank.
“This means that our base case for the balance of payments is now where our bull case was previously, and in this context Indian credit spreads look wide,” said Hjort. “It’s a bandage, no more, but it’s a significant boost to liquidity and it means reduced supply pressures. To us, this justifies an upgrade to equal-weight for Indian credit within an overall Asia credit context.”
