Avoid China domestic bonds for now, say managers
Asian bond markets should weather the rise of trade tensions with the US because of their level of local investment and sector profile, say fixed income specialists.
They believe Chinese borrowers and investors will continue to increase their dominance of the region's dollar-denominated bond market even if import taxes are introduced and the US dollar rises.
But they recommend investors steer clear of the domestic Chinese bond market, given the impact a rising dollar will have on a weakening renminbi and the likelihood of further capital outflows. The dim sum bond (CNH) market in Hong Kong is not seen as particularly attractive either right now.
Luke Spajic, Pimco’s Asia head of emerging market portfolio management, and Jack Siu, an investment strategist at Credit Suisse Private Banking, both conclude that overall the region’s bond markets are much better placed than the headline trade numbers suggest.
Asia’s trade deficit with the US has quadrupled over the past two decades and stood at $492.85 billion for the period from January to November last year. China accounted for the lion’s share, with $319.2 billion, but pretty much every other Asian country, apart from Hong Kong and Singapore, also recorded a deficit, led by Korea on $26.5 billion, India on $22.96 billion and Malaysia on $22.85 billion.
The new US administration has pledged to reverse this trend and is considering a range of import taxes and trade tariffs to encourage US companies to remain onshore and for non-US companies to invest in North America. As AsianInvestor has reported, these taxes could have a major impact on the earnings profile and share price performance of Asian companies with significant US sales.
But Spajic and Siu said the direct impact on Asian bonds would be more muted than on equities, largely because of the sector profile of the region’s borrowers.
“The countries with the highest trade deficits are not necessarily the ones with the most outstanding dollar-denominated bonds,” Spajic said.
Where China is concerned, this is not the case, as it has a 41.6% weighting in the JP Morgan Asia Credit Index (JACI), a benchmark of dollar-denominated bonds. However, as Spajic and Siu point out, the main constituents are domestically focused state-owned enterprises, property companies and banks, all of which have limited US exposure and dollar earnings.
This reduces the likelihood of rising default rates, given how few Asian borrowers have export-oriented business models.
They are also protected by the fact that the region’s dollar bond market has become ever more localised in terms of its investor base and key drivers since the Asian financial crisis (AFC) in 1997/1998. “Local tax and regulatory issues are what move asset markets here,” Spajic stated.
For Siu, Chinese policy decisions play a more critical role in determining Asian borrowing strategies and default rates than US ones do.
“The Chinese government sent a very strong signal of intent to the domestic bond market by raising repo rates by 10bp to 35bp on the first working day after Chinese New Year [February 3],” he commented. “The 2016 bull market is over, as the government focuses on de-leveraging efforts.
“This will lead more domestic borrowers to head offshore, where there’s still ample liquidity,” he concluded. “Chinese banks are still buying roughly half of all primary market issuance.”
It is easy to see why mainland banks are keen on dollar paper, with economists predicting a 15% to 20% appreciation in the US currency if the proposed border adjustment tax is introduced.
But how does offshore issuance make sense for borrowers with limited dollar earnings, given their redemption costs would also rise if the dollar strengthens? Siu thinks the swing factor will be how quickly the dollar appreciates.
“The worst-case scenario for the Asian dollar-denominated bond market is a gradual appreciation, which will prompt ever more issuers to switch to local currencies,” he argued. “But if there’s a swift adjustment, regional issuers will probably continue funding in dollars in a belief the currency will have weakened again by the time the bonds need to be repaid.”
Meanwhile, Asian borrowers have become far better at diversifying their foreign-exchange risk since the AFC, which means a rapid dollar appreciation would not cause the same level of re-payment problems it did 20 years ago.
Governments have also stepped in. Indonesia, for example, restricted its property companies from issuing in the high-yield market two years ago to forestall potential repayment problems.
A rising dollar is likely to compound a falling renminbi, and Spajic and Siu – like almost all their peers – are bearish in their outlook. Credit Suisse Private Bank is forecasting a 5% decline relative to the dollar in 2017 and Pimco a 5% to 7% decline.
“Our forecast is steeper than the 3% to 5% adjustment local investors are predicting,” Spajic explained. “If import tariffs are imposed, then that will magnify the risk of an even bigger adjustment.”
Like Siu, Spajic recommends investors steer clear of onshore Chinese bonds until later in the year.
“We think yields will remain elevated and volatile,” he said. “Over the short-term we believe liquidity will remain tight and capital outflows will continue, although the central bank will continue trying to prevent this.”
Likewise, Hong Kong’s dim sum or CNH market is unlikely to be attractive because of FX movements. HSBC, for example, is forecasting investors could make a total return of 3.5% to 4% in dim sum bonds in 2017, but close to zero in dollar terms.
Investors should also be wary of interest rate risks arising from Trump’s trade and jobs policies.
For Manu George, senior investment director for Asian fixed income at Schroders, it is about balance-sheet pressures, with funding costs set to rise in tandem with US interest rates.
In previous economic cycles, the impact of rising rates was mitigated by faster growth. Trump’s trade restrictions, however, could crimp growth across Asia as companies re-calibrate their supply chains and sales strategies. That will affect a much wider group of companies and banks even if their own direct US exposure is limited.
Siu acknowledges this is a risk. “Issuance levels in the dollar-denominated bond market will continue growing until these policies are realised,” he concluded. “At that point higher yields will hit supply.”