A monthly review and outlook of the Asian Quality Bond market.
Market review - as at February 2021
Investment grade credit spreads in Asia continued to tighten, reflecting encouraging progress with Covid vaccination programs across the region, and news that a new fiscal stimulus program was likely to be approved in the US. The US$1.9 trillion package is expected to support the US economy until conditions normalize, in turn benefiting corporate earnings worldwide.
In spite of the narrowing spreads, total returns from the asset class were negative. The JACI Investment Grade Index returned -1.17% over the month, reflecting unfavourable movements in US Treasury yields. Government bond yields rose sharply worldwide as investors suggested the anticipated rebound in economic growth will result in escalating inflation.
There was a little less economic data released than usual, owing to the Lunar New Year holiday. Anecdotal evidence suggests consumer spending in China was quite solid throughout the holiday period, with online sales maintaining their recent strength. The new issuance calendar was also affected by the holidays, although Chinese e-commerce giant Alibaba did raise US$5 billion in a four-tranche issue. Interestingly, one of the tranches was a sustainability bond; the first ever issued by Alibaba.
Indonesian state-owned oil giant Pertamina returned to the US dollar bond market, raising US$1.9 billion in a two-tranche offering. The 1.4% spread on the shorter-dated of the two securities — a five-year issue — is the lowest among USD-denominated bonds currently on issue in Indonesia, underlining the perceived creditworthiness of this issuer. Indeed, final order books were comfortably oversubscribed, enabling the issue to be completed with spreads significantly below initial guidance.
Q1 2021 investment outlook
As we move into 2021, the economic outlook seems a lot brighter than it was just three months ago. Vaccines against the Covid-19 virus are now being rolled out; more than four million doses have been administered, across nine countries. There will undoubtedly be distribution and logistical challenges in developing regions, but we are reassured by the pace at which the vaccine is being rolled out in countries including the US and Singapore. Hopefully these nations can provide support for others, for collective benefit. We are also encouraged by the high efficacy rate of the approved vaccines and the potential implications for economic activity levels. China, the first country to be hit by Covid-19 — and also the first to have it under control, even before the vaccines — has seen a strong recovery in consumer spending and retail activities. This positive trend may emerge elsewhere if the virus is contained. Many consumers are showing signs of lockdown and work-from-home fatigue, suggesting spending could pick up quite strongly as restrictions are eased.
On the political front, the new Biden administration in the US is expected to be more collaborative with major global trading partners. Some of the inward-looking policies introduced by President Trump might even be unwound during 2021, perhaps helping to rebuild damaged relations with China. A much reduced focus on Trump’s social media activity should be a further welcome development, as his random outbursts over the past four years have often spooked investors and resulted in an uptick in market volatility. In Europe, the UK has now left the European Union, following more than four years of negotiation that has dominated policymakers’ agenda. December’s trade agreement appears to have greatly reduced uncertainty in the region, which has weighed on sentiment since 2016.
While geopolitical uncertainty appears to be easing, we will continue to closely monitor US sanctions against companies on the list of alleged military-backed entities. The list includes several high profile State Owned Enterprises in China — Three Gorges, SinoChem, China National Chemical Corporation and China General Nuclear Power Group, for example — which are frequent issuers of US$-denominated bonds. The inability to sell bonds to US investors will inevitably affect the liquidity of these securities. We would also be concerned if US banks were prohibited from trading in these names, as such a move would further affect liquidity. The aforementioned names are among the highest quality credits in the Asian universe and any negative developments relating to these issuers could therefore limit spread tightening in the broader market.
Major central banks appear likely to keep monetary policies accommodative to help economies rebound from the Covid shock. We have questioned the effectiveness of monetary policies in dealing with what is a health crisis rather than a cyclical economic slowdown, and are relieved that US officials are starting to voice concerns about the unintended consequences of quantitative easing measures. There remains scope for financial instability worldwide if large-scale asset purchase programs are kept in place for too long. That said, we are not expecting tighter monetary conditions any time soon; it will take time for the current ultra-easy monetary policy settings to be reversed. Policymakers have indicated that policy settings will remain accommodative until there is “significant progress in economy recovery”.
At some stage in 2021, we expect Federal Reserve officials to provide clearer forward guidance on the interest rate front. For now, the risk with maintaining such vague guidance is that longer-dated US government bonds could sell off sharply if economic growth and unemployment rebound strongly, particularly if inflation in the US breaches the Federal Reserve’s 2% target. Such a move would affect risk assets worldwide, including corporate credit.
The Federal Reserve will likely tolerate a gradual rise in Treasury yields, in our view, particularly as 10-year yields of around 0.9% remain well below the previous low of around 1.4% in 2016. US policymakers’ commitment to keep interest rates close to zero until the end of 2023 should support the ‘search for yield’ theme in global markets. At the same, spreads for both investment grade and high yield credit in Asia remain well above the tights seen in 2017-18, and remain attractive compared to US peers. Fundamentally, credit metrics should further improve as the availability of Covid vaccines boosts consumer and business confidence.
Persistent economic headwinds still suggest default rates in Asia will rise, but a default rate of between 3% and 4% now appears most likely; much lower than forecasts from a few months ago. Stress is most likely to be seen in idiosyncratic names, with minimal spill over anticipated in the broader market. Demand for Asian credit is therefore expected to hold up strongly and any sell-off in the market is likely to be shallow, unless confidence craters and liquidity freezes up as it did in March 2020. The sheer weight of money ready to be deployed into yielding investments is significant. The demand/supply dynamic should therefore remain a powerful technical factor driving spreads tighter in early 2021, and should be supportive of a continued rally in the Asian credit market.
While current spreads look attractive against this backdrop, the sharp drop in US Treasury yields in 2020 means the all-in yield of the JACI Investment Grade index is now close to historical lows. Indeed, we are mindful that returns could be adversely affected by a quicker-than-expected steepening in the Treasury curve. With that in mind, portfolio positioning remains cautious, with higher quality names continuing to be favoured. We will look to further diversify exposures as opportunities are identified in the new issuance market.
A further spike in Covid cases — including the spread of variants of the virus similar to what we have seen recently in the UK — remains the biggest risk to the overall encouraging outlook.
Source : Company data, First Sentier Investors, as of 28 February 2021
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