Investors should brace for more Asia debt downgrades

The ongoing impact of the Covid-19 pandemic is set to see continued elevated levels of bond defaults in Asia and other parts of the world, which leaves investors with a need to be cautious – even as rate cuts cause overall bond returns to fall.

However, the region is doing better than elsewhere, and many Chinese credits in particular look well placed to weather the year, say debt experts.

Rating agency Moody’s said in a new report on Wednesday (August 5) that it anticipated that Asia Pacific non-financial company defaults would remain high for the rest of the year. It said its “Credit Transition Model (CTM) forecasts the trailing 12- month high-yield corporate default rate for Asia-Pacific will be 6% at the end of 2020 under our baseline scenario, materially higher than the 1.1% default rate in 2019”.

It added that the trailing default rate for the first half was 5.3%, with eight defaults.

Moody’s said that the higher defaults were down to the pain many companies are feeling on their balance sheets, courtesy of many workers staying home, restaurants and cinemas and entertainment facilities being forced to close in many countries.

“The ability of businesses to recover depends very much on the pace of rebound in consumer demand, which hinges on governments’ ability to restore confidence by reducing fear of contagion,” its report noted.

Howe Chung Wan, head of Asian fixed income and portfolio manager at Principal Global Investors, agreed that default rates look set to remain higher than usual, at a similar level to that predicted by Moody’s: “Current market spreads are indicating Asia default rates in the range of 4% to 6%,” he said in a new research report, also released on Wednesday.

That compares to the fund manager’s global default rate prediction of 10.6% by the end of the year.

Howe noted that the region is still “in a much stronger position in terms of growth outperformance and it is recovering more quickly because of the effective pandemic responses”.

CHINA’S UPS AND DOWNS

In particular, Howe noted that China had been the only major economy to record positive economic growth over the first half – somewhat ironically, given that the coronavirus originated from the country. That said, borrowers from the country will also be highly bifurcated in how healthily they cope with the economic pressures they are under.

“Defaults in Asia are likely going to be concentrated around smaller industrial names in China and potentially Indonesia where they have less access to cheaper funding and liquidity both onshore and offshore. This is especially true in the commodity and energy related sectors,” he said.

Moody’s largely concurred. Its report noted that it rated 22 at “B3 or below (excluding issuers that have previously defaulted) at the end of the second quarter”, up from 15 companies a year earlier. “Half of them are Chinese companies, whereas 10 are property and property related companies,” the rating agency said.

For Principal, the property sector in China offers particular appeal. Howe noted that “a majority of the US dollar issuers are the top 50 developers in China and some of them are the largest real estate companies across different geographies and property segments in the world”.

WINNERS AND LOSERS

Principal’s view is that the impact of Covid-19 has caused three broad types of corporate bond issuers. The most appealing set are “winners such technology, broadband, logistics which have benefited from the positive impact of working from home and economic activity moving online”, while the second category are borrowers that have been hurt by the economic impact of the pandemic but have strong balance sheets and lower leverage.

And lastly there are “losers in sectors which have been fundamentally exposed to Covid and the downward trend has been aggravated by Covid”.

Fears of companies seeing their balance sheets weakened has led to mounting discussion of fallen angels, or borrowers that see themselves fall from being investment grade-rated into the junk status of under Baa3/BBB-.

That said, Asia appears to be less vulnerable to this possibility than Europe of the US. Howe said that there are far fewer BBB names in Asia than other regions, and many of those that exist have sovereign-links, meaning they may be able to rely on governments if they fall into financial dire straits.

Howe also argued that there was valued to be had in Asian high yield investment. He noted that the BoAML Asian dollar index had tightened by 650 basis points (bp) after widening out over 1,000bp, but remain off the widest of pre-Covid levels, at a bigger spread than 2016. The index now sits at 8.5%.

“Spreads remain attractive on an outright basis though we are unlikely to see the same pace of rally we have seen in the last three months,” Howe said.