Investors lukewarm on Asia debt, but opportunities exist

Asian investors remain relatively uninterested in regional debt due to its expense, despite a benign outlook for the asset class, according to market experts and asset managers.

But some specific market factors, including China’s Belt & Road Initiative and India’s pumping of capital into its state banks, could help offer some upside.

Asian asset owners focused in outsourcing fixed income to third party managers in the 12 months to the end of June 2017, with the asset class accounting for nearly 40% of total net flows. Just 5% of those flows was directed into regional or Asian fixed income mandates, according to data from Broadridge Financial Solutions, a financial data and analytics firm.

“Within the fixed income space, we see the greatest appetite for developed market fixed income, and largely going into US corporate debt,” Yoon Ng, director at Broadridge Financial Solutions, told AsianInvestor.

She added that regional net inflows into Asian fixed income has been relatively low but consistent for several years in both pooled funds and segregated mandates, with about $1 billion of net inflows from Asian institutions per year over the last three years. “While we have seen increased flows from Hong Kong and Japanese investors, we saw net outflows from South Korea, which negated some of the positive uptick.”

Hong Kong and Japanese institutional investors were responsible for almost $4 billion of net inflows through third party managers into regional fixed income for the 12 months to the end of June 2017, Broadridge data shows.

Some institutional investors such as South Korea’s Public Officials Benefit Association (Poba) don’t invest heavily in Asian fixed income because it simply doesn’t offer enough yield. Poba’s targeted returns of 5% per annum is difficult to achieve given restrictions on the quality of bond it can invest in.

“We need to invest in investment grade only,” Poba chief investment officer Jang Dong-hun told AsianInvestor, “however our expected return is quite high.”

Expensive assets

Other market experts agree that Asian fixed income valuations look high, leaving little room for more performance.

Gordon Ip, chief investment officer for fixed income at Value Partners, believes this increases the challenge of finding capital gains. “[Asian bonds’ average] valuation is not very attractive in my view,” he told AsianInvestor. “If you’re looking for serious capital upside, you need to do a lot more work to find it.”

Investors are likely to focus upon coupon clipping or carry trades during 2018, according to M&G Investments emerging markets bond portfolio manager Claudia Calich. “Basically [we are expecting] middle single digits type of return, as opposed to the low double digits that we saw this year,” she told AsianInvestor.

Overall, most bond experts agreed that Asia’s ongoing economic growth and a generally stable inflation environment looks benign. This should offer a supportive environment for Asian bonds in 2018 predicted Endre Pedersen, chief investment officer for fixed income Asia ex Japan at Manulife Asset Management, in an investment outlook dated December 18. 

Alaa Bushehri, portfolio manager in emerging market corporate debt at BNP Paribas Asset Management, added the region’s default rate for the 12 months to November was just over 1%, compared to 2.9% at this time last year, citing Bank of America Merrill Lynch data.

“It’s the lowest default rate for the past two years, and we don’t expect to see a spike over the next year,” Bushehri added.

Almost all the experts that AsianInvestor spoke to believe the main risk for bond performance in 2018 is the possibility that central banks raise interest rates faster than the markets expect. This would likely cause bond values to fall and yields to spike, possibly dramatically.

However, the likelihood of dramatic rate hikes is low, NN Investment Partners senior credit analyst Clement Chong pointed out. “At this stage, US rate hikes will likely be more gradual,” he told AsianInvestor. “That should support flows into Asia.”

M&G’s Calich expects the US Federal Reserve to conduct two or three 25 basis point rate hikes during next year, based upon to the minutes of the latest Federal Open Market Committee this month.

Cautious optimism

Against this generally calm environment, a few policy developments could offer performance potential in some areas of regional debt.

Manulife’s December report predicted that government policies and reforms such as India’s bank recapitalisation and China’s deleveraging process bode well for Asian bond fundamentals.

The Indian government announced in October that it would inject Rs2.11 trillion ($32.4 billion) into a recapitalisation programme for public sector banks over the next two years, as their non-performing assets grew by around 163% between March 2015 and June 2017, according to a government press release on October 24.

This will benefit Indian bonds in the medium term, Schroders senior investment director of Asian fixed income Manu George said. “The debt to GDP level falls, improves the credit risk profile of the country, which makes it more attractive for debt investors like us,” he told AsianInvestor.

Meanwhile, deleveraging will continue as the prevailing theme of China’s fixed income market in 2018, according to Pedersen. A focus on qualitative rather than quantitative growth, reform of state-owned enterprises (SOEs), and continued stability of the financial system are factors reinforcing a favourable environment for investing in SOE debt, he noted in the report.

Alfred Mui, head of Asian credit and fixed income for HSBC Global Asset Management, believes Asian bonds will paticularly benefit from China’s Belt and Road Initiative as a key driver of activity in coming years.

Belt and Road-related infrastructure needs are enormous, especially for Greenfield projects that need to be funded from concept to completion, as reported by AsianInvestor in November. Financing such projects presents opportunities (and risks) for asset owners in the form of infrastructure debt.

China’s Bond Connect could also have a significant impact on Asian fixed income next year, especially as investors grow more familiar with the programme, M&G’s Calich said.

“I think this is an area that potentially could develop further in 2018 as investors become more comfortable with the way the market operates,” she said, “so I think that might be perhaps the largest change for next year.”