Describe your approach to research
John Woods: Our approach to both fixed income research and strategy is largely shaped by our Asian model portfolio (AMP) which means that our recommendations - good or bad, right or wrong - are captured each day in our attribution analysis to clients.
Our performance during the year has been pleasing, generally consistent, and driven fundamentally by the quality of our credit analysis. I cannot say we have identified wildly undervalued bonds, nor can I say we have identified the correct high and lows during range trading, but year to date, I am more than happy with our communication to the investor base of appropriate trade ideas, country weightings, and issue selection.
The last attribution analysis published in The View showed the AMP had outperformed the ADBI by 159bp as of end-September, equating to a total return of around 14.5%. The 159bp out-performance was a year-to-date record for us and even exceeded our year-end target by almost one percent.
To the extent that managing tracking error imposes an obvious discipline, we tend to avoid the equity-style approach to 'investing'. Tracking error means we simply cannot overweight every high yield bond and expect the portfolio to remain credible. So while a sovereign's total returns may or may not outperform is less relevant than its underlying liquidity and index weighting.
For example, year-to-date, Indonesia and Thailand are the best performers in the ADBI but investors would be hard pressed realizing that out-performance given their insignificant weighting in the Index and underlying illiquidity in both markets.
Accordingly, picking so-called 'winners' is less important than making sure every bond recommended to customers - and included in the AMP - combines to outperform the Index. Our head of asset allocation, Zhi Ming Zhang, who constructed the ADBI, did so with a heavy emphasis on liquidity, and so its inclusion criteria tends to exclude the distressed universe. Accordingly, we find our focus and client recommendations leaning towards high grade. Of course that's no bad thing in itself since HSBC is overwhelmingly a high grade shop.
Last year you were underweight Korea, long Malaysia which didn't work.
Last year Korea posted 13.3% in total returns and Malaysia 12.6%, so there wasn't a great deal in it; 70bps. Year to date, Korea has posted 8% total returns and Malaysia 11.5% so the overweight - which we have maintained - has worked in our favour. Both Dilip Shahani and Devendran Mahendran, our sovereign analysts, remain bullish Malaysia and believe it is well placed to outperform next year.
The problem with being caught the wrong way round is the cost of unwinding given that we cross our bid/offer spreads. Last year, crossing bid/offers cost the portfolio fully 100bp, so overall breakeven analysis becomes as important as outright total returns when considering buy/sell decisions.
I mention this because we're gradually scaling up the credit curve at the moment; currently, the portfolio has an average BBB+ rating. Our dollar strategist Adrian Khoo anticipates further carnage in the US corporate market over the next three or four months and believes Asia must also widen if a semblance of relative value is to remain.
However, he is also monitoring closely default risk in the States. At the point the US Treasury curve begins to flatten (and income from Treasury departments declines) and default risk bottoms out we believe a 'US Bid' for high grade corporate risk will manifest itself, in much the same way it did in Asia. US banks are currently sitting on a record USD400bn in unmatched liabilities and we suspect that a combination of economic stagnation and aversion to lending will ultimately favour high grade bonds.
Should the US Bid materialize, which I believe will be in the second quarter of next year, we are advising clients to expect a multi-year bull run in US high grade which will spill over to Asia and re-ignite our own markets.
Over a one year view, what are the credits you like from a value perspective?
Beyond range trading sovereigns, frankly, the options are as limited as the universe. Sabita Prakash, our conglomerates analyst, believes the best liquidity-adjusted value remains in HK corporates and Malaysia, particularly the belly and long end of the Petronas curve.
At the same time, recent spread widening means that PCCW offers good risk-adjusted value particularly as the credit story continues to improve. One bond we are overweight and particularly like is the CNOOC '11 which has a solid fundamental profile and investors with apparently steady hands.
What's your view on PLDT?
One of Asia's last range trading opportunities. For example, we picked up the PLDT 12s two months ago for 92 and recently unwound at 96. Yesterday they were 92. For these types of bonds fundamentals are less important than their equity characteristics. Fortunately, our telecoms analyst Imogine Baker has got a great feel for the credit and has yet to be proven wrong.
Do you think Asia has equilibrium pricing or do things always overshoot?
Both. I'm exaggerating slightly when I say Asia has two sets of equilibrium pricing; one overnight and one during the day. In reality, there are clear, countervailing interests between international investors demanding liquidity and local investors willing to pay up for scarcity.
For now, the local bid remains the marginal price setter; however, as I mentioned above, as the US capitulates, I suspect Asia's relative value will be forced into a period of rebalancing to the extent we will see a new equilibrium. Nevertheless, RV concerns apart, Asia still suffers overwhelmingly from excess demand although local bonds markets have been able to sate it to a degree.
In the last few months we've had an uneasy stand-off between the local and international bid, to the extent that real money has been largely absent from the market. As liquidity dries up, dealers and hedge funds are left to influence (volatile) spreads. This is a rather sorry state of affairs, and frankly, does not bode well for the underlying health of the asset class.
How has your model portfolio performed?
I mentioned just now that the AMP had outperformed the ADBI by 159bps as of end-September. Unfortunately - and I guess inevitably - we were unable to hold on to the gains as Treasuries tanked shortly after and we lost 50 hard earned basis points in less than two weeks!
We've been slowly clawing back (now 130bps) but volatility in the underlying and credit remains extraordinary. In fact I think Treasuries will soon end their correction although I also believe Asian credit will remain under pressure for reasons already mentioned. Hence the on-going scaling up the credit curve.
Can you predict an upgrade and a downgrade that will have an impact on the Asian markets in 2003?
Against a slowing growth environment in the US, I suspect next year could well be a bumper year for ratings actions by the Agencies. Starting with the sovereigns: you've got to believe the ROP's rating will experience pressure unless it can demonstrate fiscal discipline. Simultaneously, if Moody's new sovereign methodology is applied to Thailand and India, both these sovereigns could well be upgraded. However, market reaction to these events will be limited given existing liquidity.
In the corporate universe, Sabita is on record with her view that Hutchison is likely to be downgraded by S&P to A-; further ratings actions by the agencies will depend on the reception to 3G and other asset acquisitions. Conversely, we think PCCW could be upgraded by S&P to BBB+ towards the end of 2003 assuming they continue their various de-leveraging strategies. Similarly, Wharf is likely to be upgraded by Moody's to Baa2/stable from Baa3/positive assuming there is no restructuring with parent Wheelock. Away from Hong Kong, SingTel could be downgraded by both agencies if it fails to show improvement in credit profile and KEPCO could be upgraded by Moody's from Baa2/positive if it makes material progress in selling the gencos.
