Bond investors wait for a recovery signal
Angus Hui, Asian fixed-income fund manager at Schroder Investment Management, says he will remain defensive until there is more clarity on what impact the US slowdown will have on Asia.
WhatÆs your strategy for 2008?
In the next 12 months as a whole, we are positive on high-grade paper. High-grade valuations on banks and corporates are cheap compared to a year ago. While there are also good investment opportunities in the high-yield space this year, security selection is very important, and our high-yield investments will be on a case-by-case basis. We think there will be divergences in performance among credits, and our bottom-up credit selection focuses on names that have multiple funding sources (for example, an ability to tap the local bond/syndication markets), low refinancing risks and sectors that have low correlations with the US slowdown.
Overall, we remain cautious and await for signs of market stability in the global/US credit markets before committing any fresh capital.
What is your sentiment in view of the current state of the market?
On a more near-term basis, our strategy in Asian bonds focuses on adding value through duration and currency management, which benefits from easing interest rate cycles in the developed markets, US dollar weakness and structural appreciation trends in Asian local currencies. We remain fairly defensive even though high-grade is attractively priced. This is because there is still not enough clarity regarding what is going on in the US and this is reflected significantly in Asia. Spreads have widened even more than in the US in an environment where the fundamentals remain quite strong. This is because the market here is still quite small so when market liquidity diminishes, the risk premium is exposed significantly.
From a valuation point of view, the size of the Asia market also makes it difficult to decouple. Fundamentally, Asia is stronger than the US, but in terms of valuations itÆs hard to see it that way: AsiaÆs credit markets have mirrored the US and we need to see the US markets improve before we start to see Asia perform as well.
Moreover, there has been a change in investor mind-set generally which is affecting spreads. In the second half of last year, everybody was concerned about the liquidity in the banking sector. Since then, injections from central banks have improved the liquidity. But now the focus has shifted to the risks of an economic slowdown and/or a US recession and, in my view, credit spreads still need to adjust since the focus of the market has changed. This was partly why the credit market had a very weak start for the year.
Another reason to be defensive is the pipeline of new issues due to come to market. In other market sell-offs, investors were happy to start buying when valuation were cheap, but this is more challenging now due to the heavy supply overhang from postponed deals. In the US, many good-quality investment-grade corporates are pricing at a 30bp-40bp discount. In Asia, recent new issues have come to market only thanks to very high spread concessions. This means that, although valuations are cheap, investors would still rather wait for new issues given the potential concession instead of going to the secondary market, especially where liquidity is weaker for existing issues. This is particularly true for sectors with significant dollar funding needs.
In high-yield, while we have a positive long-term view on the China property sector, most of the supply pressure is in Chinese real estate, and in the near-term we are quite defensive regarding this sector. As well as a supply overhang, investors in Chinese property names need to contend with government policy risk. Companies not only face difficulties raising money in the dollar bond market, but also in the equity markets since their share price has dropped significantly due to austerity measures implemented by the government. Moreover, such policies have also affected these corporatesÆ access to the local bank market. On a relative basis, BB-rated property names which benefit from more financial flexibility, with better geographical diversification and a stronger record will ride through the challenge posed by policy risks better than their smaller counterparties.
What is your general outlook on Asia?
In the long-term, we think that even if the US goes into a recession, the impact on Asia will be manageable. Fundamentals in most banking sectors are strong, corporate leverage is relatively low and most sovereigns in Asia are in good shape. But right now we are keeping a close eye on headline news, and awaiting further clarity regarding a US slowdown, and how it will impact the Asian economies
What will mark the beginning of a recovery?
Fundamentally the market needs to see more clarity on the impact to the banking sector, and feel confident that the monetary policy/fiscal stimulus packages will help to get economies back on track. This will help enhance risk appetite. More specifically in the Asian credit markets, the key is to see a stabilisation in the US credit market. Then, we will see new issues come to market with a tighter concession, and the bonds will still perform in the secondary market. In the next few months, we expect some windows for deals to price which will succeed if the concession is wide enough. However, people will only begin to have confidence when bonds manage to price tighter, and continue to perform well in secondary.
How harmful is it to the market that deals are coming at such wide spreads?
In the longer term, it is a natural and healthy market development to have more new issues. In the short term, from a technical perspective, a new issue releases some of the supply pressure and this is obviously constructive. On the other hand, this is causing spreads to widen on existing paper because of generous new issue premiums. So thereÆs a trade-off.
In the next 12 months as a whole, we are positive on high-grade paper. High-grade valuations on banks and corporates are cheap compared to a year ago. While there are also good investment opportunities in the high-yield space this year, security selection is very important, and our high-yield investments will be on a case-by-case basis. We think there will be divergences in performance among credits, and our bottom-up credit selection focuses on names that have multiple funding sources (for example, an ability to tap the local bond/syndication markets), low refinancing risks and sectors that have low correlations with the US slowdown.
Overall, we remain cautious and await for signs of market stability in the global/US credit markets before committing any fresh capital.
What is your sentiment in view of the current state of the market?
On a more near-term basis, our strategy in Asian bonds focuses on adding value through duration and currency management, which benefits from easing interest rate cycles in the developed markets, US dollar weakness and structural appreciation trends in Asian local currencies. We remain fairly defensive even though high-grade is attractively priced. This is because there is still not enough clarity regarding what is going on in the US and this is reflected significantly in Asia. Spreads have widened even more than in the US in an environment where the fundamentals remain quite strong. This is because the market here is still quite small so when market liquidity diminishes, the risk premium is exposed significantly.
From a valuation point of view, the size of the Asia market also makes it difficult to decouple. Fundamentally, Asia is stronger than the US, but in terms of valuations itÆs hard to see it that way: AsiaÆs credit markets have mirrored the US and we need to see the US markets improve before we start to see Asia perform as well.
Moreover, there has been a change in investor mind-set generally which is affecting spreads. In the second half of last year, everybody was concerned about the liquidity in the banking sector. Since then, injections from central banks have improved the liquidity. But now the focus has shifted to the risks of an economic slowdown and/or a US recession and, in my view, credit spreads still need to adjust since the focus of the market has changed. This was partly why the credit market had a very weak start for the year.
Another reason to be defensive is the pipeline of new issues due to come to market. In other market sell-offs, investors were happy to start buying when valuation were cheap, but this is more challenging now due to the heavy supply overhang from postponed deals. In the US, many good-quality investment-grade corporates are pricing at a 30bp-40bp discount. In Asia, recent new issues have come to market only thanks to very high spread concessions. This means that, although valuations are cheap, investors would still rather wait for new issues given the potential concession instead of going to the secondary market, especially where liquidity is weaker for existing issues. This is particularly true for sectors with significant dollar funding needs.
In high-yield, while we have a positive long-term view on the China property sector, most of the supply pressure is in Chinese real estate, and in the near-term we are quite defensive regarding this sector. As well as a supply overhang, investors in Chinese property names need to contend with government policy risk. Companies not only face difficulties raising money in the dollar bond market, but also in the equity markets since their share price has dropped significantly due to austerity measures implemented by the government. Moreover, such policies have also affected these corporatesÆ access to the local bank market. On a relative basis, BB-rated property names which benefit from more financial flexibility, with better geographical diversification and a stronger record will ride through the challenge posed by policy risks better than their smaller counterparties.
What is your general outlook on Asia?
In the long-term, we think that even if the US goes into a recession, the impact on Asia will be manageable. Fundamentals in most banking sectors are strong, corporate leverage is relatively low and most sovereigns in Asia are in good shape. But right now we are keeping a close eye on headline news, and awaiting further clarity regarding a US slowdown, and how it will impact the Asian economies
What will mark the beginning of a recovery?
Fundamentally the market needs to see more clarity on the impact to the banking sector, and feel confident that the monetary policy/fiscal stimulus packages will help to get economies back on track. This will help enhance risk appetite. More specifically in the Asian credit markets, the key is to see a stabilisation in the US credit market. Then, we will see new issues come to market with a tighter concession, and the bonds will still perform in the secondary market. In the next few months, we expect some windows for deals to price which will succeed if the concession is wide enough. However, people will only begin to have confidence when bonds manage to price tighter, and continue to perform well in secondary.
How harmful is it to the market that deals are coming at such wide spreads?
In the longer term, it is a natural and healthy market development to have more new issues. In the short term, from a technical perspective, a new issue releases some of the supply pressure and this is obviously constructive. On the other hand, this is causing spreads to widen on existing paper because of generous new issue premiums. So thereÆs a trade-off.
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