Asia credit has underperformed its US equivalent and the region’s corporations are likely to end the year at levels wider than current spreads. But investors should beware attractive-looking sovereigns as a majority of the risk is on the rates side, according to commentators.
Over the past two months, emerging market bonds have experienced a dislocation, in which funds benchmarked to sovereign indices have seen more severe outflows than those benchmarked to corporate indices. The Barclays global emerging markets corporate index, for example, has lost 3.75% year-to-date, whereas the equivalent sovereign index has lost 6.5%.
“This dislocation has been driven by weaker flows into sovereign and quasi funds rather than a justifiable fundamental reason. A fundamental approach suggests that, if anything, corporates should be cheapening versus sovereigns, not richening,” said Aziz Sunderji, credit strategist at Barclays.
“The credit cycle has peaked and defaults are gradually rising and this trend should accelerate as emerging market growth slows, capital flows weaken and foreign exchange volatility rises. At the least, we expect these developments to result in a reversion to historical spread ratios between corporates and sovereigns.”
Unusually at the moment, credit spreads and UST yields are positively correlated, which means a sell-off in USTs will result in wider credit spreads and corporates will underperform, he said. However, this positive correlation is likely to be a short-term phenomenon and interest rate risk is increasing faster than many anticipated.
Many analysts assumed that figures from the US would continue to be weak for a while, which would result in low rates for the foreseeable future. But data released on August 1 surprised the market, leading to an overnight jump in the 10-year US Treasury yield from 2.58% to 2.71%.
The Institute for Supply Management (ISM) index – a measure of national factory activity, rose from 50.9 in June to 55.4 in July. This is the largest increase in 18 years and the second biggest in the history of the index, according to DBS.
Unemployment data is yet to be released at the time of going to press, but analysts expect the figure to fall to a near four-year low, according to Reuters. GDP growth for the second quarter was 1.7% quarter-on-quarter, up from 1.1% in the first quarter. This has led many strategists to stress a focus on credit spread rather than interest rate risk for the second half.
“The US treasury component has been and is going to see further negative total returns. At the same time, when yields are backing up this should reflect a stronger economic backdrop which means lower defaults and a lower credit risk premium,” said Edwin Chan, head of Asian credit research at UBS.
“As a result we prefer higher yielding credits. We are underweight sovereign bonds because there is less of a credit spread cushion to offset the back up in US Treasury yields and we are overweight corporate bonds as a result because they should benefit from a stronger economic backdrop.”
Others agree: “Defaults will remain low and credit spreads will remain tight so there is value in the corporate space especially in Asia where CDS [credit-default swap] spreads in dollar bonds are wider than what you can find in Europe or in the US,” said one Hong Kong-based senior investment analyst at a private bank.
The Markit iTraxx Asia index of 40 investment-grade borrowers in Asia ex-Japan was at 143.4 at the time of going to press, compared to the Markit iTraxx Europe Index of 125 investment grade companies at 97.2 and the Markit CDX North American Investment Grade Index at 74.6, according to Bloomberg data.
Within high grade, a yield cushion can be achieved by remaining benchmark netural but switching from bonds that are beaten up to those that are underperforming, said Chan.
“On the high grade side we will switch into Hong Kong and China from Singapore and Malaysia to generate extra yields. In addition we are selling higher dollar price bonds to go into lower dollar price bonds as clients are looking to raise cash,” he said.
“Otherwise we have been recommending shorter duration to replace interest rate risk with credit risk. If you do not have portfolio constraints, for a 3% bond that you own I would go from a 10-year ‘A’ rated bond to a two-year ‘B’ name.”
On the high yield side, in addition to the yield cushion, bonds naturally have a shorter-duration than their investment grade counterparts, which will increase their appeal in the face of rising US dollar rates.“We are overweight Asia high yield and underweight investment grade and local currency bonds in the region. The risk is in the rates side,” said the senior investment analyst.