US President Donald Trump’s decision to impose tariffs on a wide range of his country’s trading partners has put renewed pressure on Asia’s G3 bond markets just as they were starting to regain their footing after a difficult few months.
The abrupt change of investor sentiment, which came on May 29 after Trump announced a 25% tariff on $50 billion of Chinese goods, meant the month's activity ended with a nasty sting in its tail.
Such bursts of geopolitical volatility may come to be the defining motif for 2018, superseding the fall-off in issuance and rebound in US Treasuries, which had allowed Asian credit spreads to begin stabilising from the middle of the month onwards.
Unsurprisingly, credits at the lowest end of the ratings spectrum have taken the sharpest hit over the past few days. Worst affected are the all-dominant Chinese property companies, which are also grappling with the shadow of default risk as the government continues tightening onshore lending conditions, allowing companies to default.
B- rated Guorui Properties, for example, saw its 7% March 2020 bond fall 11 points in the space of two trading sessions after news of a potential new issue broke. It closed June 1 on a mid-price of 82.04% to yield 11.977%, according to S&P Capital IQ data.
The days of double-digit yields for China’s lowest rated property credits are clearly back for the first time since 2015.
Prior to this, Asia’s new issue market had been “feeling a bit calmer” according to Derek Armstrong, head of Asia Pacific debt capital markets at Credit Suisse. This is largely because there was a significant drop in issuance volumes in May 2018 compared both to the previous month and the same month a year ago.
Dealogic figures show Chinese issuers raised a total of $9.81 billion in G3 currencies during May 2018, just 38.7% of what they did in April 2018 and 71.4% of what they did in May 2017.
Shrivelling volumes in China’s onshore market have been even more marked. May’s $12.19 billion issuance represented just one-quarter of April’s and one-eighth of March’s.
Overall, Asia ex-Japan borrowers have raised $143.66 billion to the end of May compared to $160.58 billion over the same period last year according to Dealogic. However most banks and fund management houses still expect 2018’s issuance total to surpass 2017’s.
This suggests the second half of the year could be very busy, providing a clear signal of which direction credit spreads may head in. Supply will continue weighing on the market unless borrowers find themselves blocked entirely, or decide to access other financing channels.
Armstrong says June’s activity will “largely depend on some level of stability returning to the new issue market.” However, he also adds that macro headwinds, including Italy’s messy politics and its looming sovereign debt crisis, are “likely to have an impact on investor sentiment".
INVESTORS CALL THE SHOTS
How should borrowers navigate their way around this? There is a simple answer according to Arthur Lau, co-head of emerging markets fixed income and head of Asia ex-Japan fixed income at PineBridge Investments.
It is one he would never have imagined saying even one year ago. “If issuers want to raise money then they need to please investors,” he told FinanceAsia.
In March and April, this demonstrated itself through shorter maturities, which help investors to mitigate duration risk and elevated new issue premiums, which give them more secure pricing cushions.
In May, floating rate notes (FRNs) also made a comeback.
Resetting bonds over three-month Libor insulates investors from interest rate risk, though it has the opposite effect on borrowers unless they swap the proceeds back to fixed rate, in the process raising their overall cost of funding.
In its monthly credit note, Mizuho highlights that 44% of May’s G3 bond issuance took an FRN format, led by some of the month’s largest deals: $1.5 billion from each of Kexim and ICBC Leasing, plus $1.3 billion from Bocom. There was even a smattering of corporate FRNs including a $650 million transaction by China Vanke.
PineBridge Investments' Lau said his group's overall strategy was to “reduce beta by shortening our duration and selling long duration bonds, which are trading at tight levels.
“We’ve also been moving into higher IG names and avoiding headline credit issues, which might suffer in the event of a trade war between China and the US,” he added.
INVESTMENT GRADE VS HIGH YIELD
Lau believes investment grade credits are likely to be more resilient than the high yield because their fundamentals are stronger. And the lower down the credit curve, the more marked that divergence is likely to be.
“We may see more widening on the high-yield side,” he said. “I think current investment grade levels are pretty fairly valued at the moment.”
Indeed, some of the month’s bigger investment grade deals traded well, not least the largest one of all: a $2 billion twin tranche offering by Indonesia’s PLN, executed in the middle of the month.
Both its $1 billion 5.45% 2028 note and $1 billion 6.15% 2048 note traded up almost five points each, before hitting the same end-of-month buffers, which brought them back down about two points again.
Likewise, Malaysian credits have demonstrated signs of reversing the long decline that rode hand-in-hand with investors’ diminishing faith in the country’s corruption-ridden government.
Two years ago, for instance, Petronas’ 7.625% October 2026 bond was trading around 140%. It hit a nadir around the 123% mark, one week after the opposition scored a stunning political reversal of fortunes on May 10 and investors fretted about a deterioration of relations with China.
Since then, the quasi-sovereign complex has begun inching tighter, with Petronas’ 2026 note quoted at 125% on June 1.
Lau does not believe Asia has yet become a “screaming buy”, given the region is still trading around its five-year averages. One of his least favoured countries is Indonesia.
“It’s been a tough time for the Indonesian credit market,” he said. “Investment and consumer sentiments are low, the Rupiah is under pressure and the policy environment is more challenging.”
As a result, PineBridge is repositioning into short-dated Chinese high-yield bonds, notwithstanding the property market’s current travails.
“Chinese property companies are still reporting very decent earnings,” he argued. “The problem is a technical one: there has just been too much supply. Therefore, we are much more positive about the sector than Indonesia and think it will rebound once the pipeline is cleared out.”
EMERGING MARKETS ROUT
As May began, many investors were also wondering when emerging markets as a whole would hit bottom after a brutal couple of months.
In a recent research note, Morgan Stanley argued the global EM sell-off was “positioning driven” because real money investors had entered the second quarter still overweight in both local and hard currency EM bonds.
“Once the US dollar started to rally and US Treasury yields backed up, investors had little choice but to return to benchmark exposure,” the US investment bank said. "As negative returns materialised, fund outflows followed.”
Investors received the answer to their question on May 9, when Asia’s emerging and frontier market sovereign spreads started to turn around. EM fund flows followed their lead a couple of weeks later after a month of solid redemptions.
Having lost about three to four points during the first two weeks of the month, benchmark sovereign paper from Indonesia, Mongolia, Pakistan and Sri Lanka had rebounded between two to four points by May 29.
However, as global trade tensions resurfaced at the end of the month, Sri Lanka and Pakistan both dropped back again. Does this mark a resumption of the down-cycle?
Credit Suisse’s Armstrong says much will depend on the dollar. “The direction of US interest rates, and importantly the strength of the US dollar, are likely to dictate EM fund flows over the coming months,” he commented. “There have been some recent outflows but we’re still comfortably positive on a year-to-date basis.”
PineBridge Investment’s Lau agrees. “We do agree that some value is starting to open up because of overselling in certain parts of the EM universe,” he said. “But it’s finely balanced.
“Spreads will widen further if the US dollar continues to appreciate and there are more outflows back to the US,” he continued. “But we’re also mindful of the medium-term and unresolved questions about America’s twin deficits.”
One of May's big moves concerned US Treasuries as investors sought save haven bonds. As a result, 10-year Treasuries rallied strongly during the middle of the month, but pulled back again right at the end, closing 11.4bp tighter at 2.822%.
All eyes are now on June’s Federal Reserve meeting, when the market participants almost unanimously expect a rate hike.
Lau concludes that, “The focus is starting to shift to the second half of the year and when the rate cycle will pause or stop. We are very conscious about recession risk at the end of 2019, beginning of 2020.”
As the first half of the year draws to a close, Asian economists are also mulling whether to downgrade their growth forecasts across the region as funding costs rise and trade tariffs start to bite.
If they do, one of the key supports for the Asian bond markets will go with them. So will the region’s relative value to the rest of the world.
In the year to the end of May, the JP Morgan Asia Credit Investment Grade Index was 69bp wider at 4.3%. It has not performed as badly as the CEMBI Investment Grade Index, which has widened 79bp to 4.67%.
But it has underperformed the Bloomberg Barclays Global Aggregate Index, which is out 50bp to 2.94%.
