Sunday, 21 April 2019

IFR Asia Outlook for Asian credit Roundtable 2018: Part 2

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  • Cliff Tan
  • Michael Taylor
  • Rethinking rates
  • Avinash Thakur
  • IFR Asia Outlook for Asian credit Roundtable 2018

DESMOND HOW, GAOTENG: This is also why domestic CNY bonds are regarded more as a rates product than a credit product, as Paul mentioned. A big part of it is because credit differentiation is very low. Everything that is not Triple A will be high Double A. It doesn’t make a lot of sense to foreign investors. And the default rate, traditionally, has been low. There was a small spike last year, but even then, we’re talking about less than 1%. And if you look at this year’s onshore debt that’s maturing, one house alluded this figure of CNY5 trillion, or CNY3 trillion without puts. It’s a huge amount to refinance, and right now the onshore market is not conducive. Over the past two years, the NDRC (National Development and Reform Commission) has played a very big part in deciding how much a company can issue onshore or abroad.

This year we’re definitely going to see more managed defaults. As Michael pointed out, the government has to think about which sector is going to have the lowest contagion risk. And as I mentioned earlier, the agenda this year is more about financial stability. I don’t think the government plans to do anything that would have a big ill effect on the whole market.

CLIFF TAN, MUFG: It’s worth looking at how China is treating non-Chinese rating firms – and I’m not just saying that because Michael is here.

I’ve been a big proponent of developing the Asian local bond markets since the financial crisis 20 years ago. Back then, most Asian governments largely looked at bond markets as a way to raise resources. That is not the reason the bond markets are so important: it is because of credit differentiation. Bond markets have such power because they can lead to a more efficient allocation of capital than bank lending. And very few governments have picked up on that. Now, there has been some development in the bond markets in South-East Asia, and that’s helped. But, in China’s case, raising resources is still the main function of the bond market. And that’s why they treat foreign rating agencies so poorly. I won’t mention any names, but from a professional standard, some of the work of the domestic rating agencies is very poor.

If China wants to encourage foreign interest in its bond market, it’s got to raise its game there, and I would be watching how the foreign raters are treated.

AVINASH THAKUR, BARCLAYS: I take comfort in the Chinese regulators learning from the market and moving in the right direction. The move may not be as fast as markets would like. But I think everything that we’ve talked about shows the regulators have tried to move in the right direction.

The basket currency peg is a case in point. We had that mini-crisis with the RMB at the beginning of 2016, and you had the regulators meeting with banks here in Hong Kong. They came up with a solution which has worked for them.

The regulators are obviously aware of the issues that they’re facing right now, and that’s why there is this whole drive towards financial stability.

PAUL AU, CMBI: I think the regulators and the banks are very sophisticated. Over the last ten years the level of sophistication has increased significantly, catching up to global standards. At China Merchants Bank, the things I see are very international. The way the management looks at performance is at international standards. To Avinash’s point, the regulators know what’s going on. The banks have been big issuers of AT1 preference shares, initially with the big state banks and six or seven of the smaller regional banks last year. Why? Because they understand that they need extra capital support, and such issuances were well supported by the regulators, who want to ensure that they are sufficiently capitalised.

IFR ASIA: This all suggests to me that the regulators are not about to close the borders. That flow of offshore China issuance, which has been such a growth story in recent years, is that going to continue?

PAUL AU, CMBI: I think it will. The doors are definitely not closed. Now from talking to a lot of investors, again, policy is the key concern. Some people might say they are the right policies and the right steps, and some people may have different views. I think the market is concerned about global policy missteps that may cause market volatility.

IFR ASIA: If you had to put a number on it, how much offshore China issuance are we talking about this year? Last year we had over US$300bn of G3 issuance from Asia, and probably 50% of that was China.

PAUL AU, CMBI: More like 60%.

IFR ASIA: Are we looking at similar kind of flow this year?

AVINASH THAKUR, BARCLAYS: Most certainly. And I think the issuance in January and February, despite the slow market, points us to that direction. China will keep growing. If you look at the size of the domestic capital market compared to size of the economy, it’s still minuscule. Companies have no choice but to look at international capital markets.

And you will have companies continue to go towards international capital markets, because that’s one of the few viable sources for them to raise capital. They have no choice. We hear about 10 to 15 new issuers looking every month – and Paul can talk more about that, because he’s on the ground there. It’s not going to stop any time soon.

PAUL AU, CMBI: There’s a lot of new names. The trend is that issuer ratings are going down the curve. You see more new names in non-investment grade territory; that trend is very apparent.

IFR ASIA: Before we get into high-yield, Paul, what’s your take on this China supply? You mentioned some concerns around the investor side. What about the issuer part of that equation?

PAUL CARRETT, FWD: I’m interested to see where the conversation goes in respect of high yield, because, as you say, companies want to go offshore but they’re going to be subject to the disciplines of a professional global investor base. It will be interesting to see how they go, and if investors push back on either pricing or covenants.

I still hope that economics will trump the policy issues. Ultimately, in the long run, that’s what you would expect. I still can’t get past the fact that we’re pretty late in the cycle and, while we think it’s a benign environment, at some point the markets may well see a crack. I think we’re reasonably sanguine around this table about the outlook for this year, but I think we have to be very cautious of some of the risks that will emerge at some point in time.

We know credit will crack at some point, but is it this year, is it next year, is it the year after? I don’t know when. But we’re certainly looking out for it. I think some of this issuance will test that demand pretty heavily.

IFR ASIA: High yield is a potential stress point, just because that’s where you expect to see more defaults.

CLIFF TAN, MUFG: But year to date, actually, high yield has outperformed investment grade in Asia.

IFR ASIA: How much of that is down to the very high coupons people are paying to get their deals away? We’ve seen quite a few of those transactions recently.

AVINASH THAKUR, BARCLAYS: I think you will see differentiation in credit more and more. The days when people would buy everything that comes their way have gone. We do a lot of high-yield business. When we talk to investors, the difficult questions are being asked and with more and more credits coming out, you will expect the issuers to do a much better job of disclosure to make sure they can get an international following.

But, again, we’re seeing a move in that direction. If you go and talk to a high-yield issuer in China or, for that matter, anywhere in Asia, you’d want to see pushback on some of these issues. They’re willing to listen to what they need to do to access capital.

Moody’s, in a recent report, put default rates here at an all-time low. So far, there’s no real sign that Asian issuers are trying to do anything out of the ordinary. They’re trying to follow the rules and go and raise capital. They need the capital to grow. Some of them will pay up, and that drives those strong performances. But a lot of them are also trading at all-time lows. There are people who recognise that there’s value in these credits coming out of China as well.

PAUL AU, CMBI: On the pricing point, some of the issuers are trading at all-time tights. You have Single B and low Double B real estate names at 5%-6%. Five years ago, they were at 12%, 13% when they first issued. If you look at China high yield, the default rate is, actually, very low. And we have seen some examples of credit stress that actually came out okay, like Kaisa Group. People are getting a bit more comfort about recovery rates.

Now, this particular asset class started out more as a real estate space. It was all the real estate developers who couldn’t raise funding onshore six, seven years ago, and needed the offshore money. They were willing to pay up – and they were able to pay up – because their operating margin was higher than it is now. The real estate segment represented roughly 55%-60% of the entire China high-yield market last year, and I think that percentage may drop a little bit, because you’re going to see more new issuers from different segments. Energy, new energy, old energy, energy logistics… That’s what we’re seeing. It’s going to be a more diversified and more colourful high-yield space than just real estate.

DESMOND HOW, GAOTENG: This is also a new challenge for international asset managers. Last year we had about 130 debutant new issuers, almost twice as many as in 2014. So, the breadth of the market has increased tremendously. And if you think about the number of research analysts we have on the buy-side, on average, the coverage is not enough. That poses a challenge for international investors, and that’s why the Chinese investors pick up the slack, because they are more familiar with these Chinese debutante. They have existing relationships onshore, they know the company already and don’t have much credit work to do.

Anecdotally, Asia’s annual default rate since 2010 has been just 1.6% on average, which is pretty low. And Paul also pointed out the recent recovery rates are, actually, very high. The property name that he mentioned was almost a 90% recovery. And the recent commodity trader listed in Singapore is talking about 50 cents on the dollar for the senior notes, versus an average recovery rate for US and European corporates of about 40 cents. Asia still offers a pretty low default rate and high recovery. That’s the investment case for putting money into Asian high yield.

IFR ASIA: Does it feed into the rates picture as well? I hear this argument a lot that a higher coupon gives you a cushion if rates are going up.

PAUL AU, CMBI: When rates go up, the economy is doing better, so spreads should compress and from a technical demand standpoint, investors are more likely to go down the curve, because they see less value in buying a 10-year Single A bond. In fact, a long-dated high-grade bond is riskier because of the potential rates movement. A 10bp movement in the 10-year Treasury overnight is close to a point in your Single A holding, if you don’t hedge. That’s why people are moving down the curve to take more credit risk in an interest rate hike cycle.

DESMOND HOW, GAOTENG: I did some work on looking at the responses of credit spreads to a 50bp movement in Treasuries since 2008. Over the course of the next three months, what’s the spread impact? It is inconclusive, actually. But Paul’s explanation makes sense that a 10bp sell-off may give us something like 5bp in spread compression, meaning it’s partially absorbed by the spread.

One reason for that is the investors who have come in more recently are total return players, not spread players. Typically, a spread player would hedge against Treasuries. If there’s a back-up in spreads but economies are doing better, that is supposed to be a buying opportunity. But, because a lot of investors are total return players they saw spreads back off and they shied away. In fact, there was also some additional selling. So, I think it’s because of the segmentation of Asian buyers that we don’t see a conclusive opportunity in spreads if there’s a big sell-off in Treasuries.

PAUL CARRETT, FWD: It’s not the way we would manage money at all times across the cycle, but insurance companies, as an industry, tend to be long-term absolute return investors. If they need to earn 4% over the long term, then they start reaching for yield when rates go lower. You can look at how many insurance companies have been going down the credit curve as rates have fallen.

Higher rates take some of the pressure off some of them. While they might have bought some of the edgier credits in the past, they may well seek to go up the curve, even if spreads remain tight, because they can hit that absolute return target, whether it’s 4% in dollars or whatever it might be.

It also depends which segment of the market is dominating investments into new issuance at any point in time. That’s why you’ll get ambiguity. Insurance is probably pretty constant there. New premiums come in every week and they’re deploying into these markets all the time. They’re not always the marginal buyer, but they’re a pretty stable source.

That is the case for higher rates taking a bit of pressure off credit spreads tightening further.

AVINASH THAKUR, BARCLAYS: If rates are going higher, that also means that your own cost of raising funding goes up. So, you keep chasing the differential that you require. And that’s why when the Treasury is high, Libor has gone up. Investors will always want a return over the base rates, so I would think the high yield environment will continue to be conducive.

In fact, high-yield returns tend to be more correlated to equity than high-grade bond indexes. So, high yield is something that I would be more positive about. There will still be a lot of interest in that segment.

IFR ASIA: Is there any room for credit spreads to go tighter? The iTraxx investment grade index in Asia is at 66bp at the moment; 12 months ago, we were at 91bp.

AVINASH THAKUR, BARCLAYS: We’ve seen good returns over the last year, except for the last few months. But the upside will always be more challenging from where we’re sitting, close to all-time lows.

CLIFF TAN, MUFG: I agree with that as well. I have some sympathy with what Paul said, that investment-grade credit may be more vulnerable in a rising rate environment. But I’ve had a view for a couple of years now that investment-grade credit just looks slightly ridiculous.

IFR ASIA: As long as there’s more money coming in and new investors to support it, then that’s fine.

PAUL AU, CMBI: As Paul said, it depends on the type of investors you’re looking at. For insurance companies, I would imagine the proportion of high grade is going to be higher. Policyholders might demand 4% now, but that probably will go up over time as rates rise.

The mix of investors that I’m seeing right now is increasingly driven by total-return players, and their appetite for risk is actually higher than some of the investors who have been around for a long time. Hence, I’m quite positive on the high yield side of things.

DESMOND HOW, GAOTENG: I would describe it as “We’re in the last mile, but we’re not there yet”! If you think of a traditional credit cycle of around 10 years, we are about done, but this cycle has been extended because of concerted global monetary policies.

Probably a better example for spreads would be the JP Morgan Asia Credit Index, which puts IG spreads at 164bp right now. The all-time tight was actually early 2007 at 83bp. In CDS terms, China was at 12bp pre-crisis. So, there’s definitely room for compression!

AVINASH THAKUR, BARCLAYS: The credit spreads have been getting tighter over the last few years. The probability of spreads going even tighter keeps going down. I’m not saying that it’s not going to go down any further, but the probability falls with every tightening.

PAUL CARRETT, FWD: We are confident that there’s an absolute lower band for credit spreads, and that’s zero!

The point about asymmetry is important. Your upside is limited from here, so at the classic late stage of the cycle your portfolio construction is going to matter a lot. Picking the right bonds is clearly going to matter a whole lot more than it did maybe a couple of years ago. Therefore it’s time for a bit of caution and serious research before we get to know some of the new names that we’ve not known before.

IFR ASIA: Are there any countries or sectors that you expect to outperform this year? Or is it all a bit of a broad brush across Asia?

MICHAEL TAYLOR, MOODY’S: I think it’s a pretty broad brush across Asia, because, to come back to something I said before, the Asia growth story remains pretty much intact, despite the risks of rising protectionism. Within Asia, there may be one or two where we do see some further upside. I think Indonesia is an interesting one, where we have seen some progress on reform. It’s very much like India, where we had seen some reform progress, but it hadn’t been fully implemented. We upgraded India’s sovereign rating at the end of last year.

Indonesia at the moment is growing at around 5%. If they can get those reforms right and actually start seeing the full impact of the reforms and infrastructure investment, then that’s a country that could raise its potential growth rate. That would then become quite interesting from an investment point of view.

India and Indonesia are also worth looking at, if we do get into a more protectionist kind of environment. Those economies are large and are still relatively closed, with large domestic markets. In the event that we do move to a more protectionist world, those are the characteristics you’d probably want to be looking for.

IFR ASIA: Is Indonesia not too correlated to China? It might be insulated from the US, but do you see it very linked to China’s fortunes?

MICHAEL TAYLOR, MOODY’S: I wouldn’t say that it’s very linked. I think one of the features of Asia’s economies more broadly is that the linkages with China have grown much deeper over the last 10 years. What happens in China does have a much bigger impact now in Asia. India, I think, is still not quite as coupled to China as some of the other economies in the region. But, certainly, what happens in China does matter a lot for Asian credit.

CLIFF TAN, MUFG: On Indonesia, I’m a bit worried about what happens after (President) Jokowi. The fact that Indonesia is still growing at 5% I would say is a failure of reform. This is a country that could easily grow at 6%, 6.5%. I think Jokowi is a relatively clean guy, but I don’t think he’s managed to wrangle the government into the kind of reforms that are necessary. And I’m even more concerned what happens after him.

This is one of the EM countries where foreign investors really need to have faith in the reform process. And foreigners are so important in the local bond market. If something really does hit the fan, investors’ first reaction is not going to be to say, “Hey, this is a large, Muslim country that has a really good domestic demand base.” That’s not what they’re going to do. They’re going to leave, first of all, and then take a look around.

IFR ASIA: That sounds fair. Any other hot sectors?

AVINASH THAKUR, BARCLAYS: We’re starting to see some infrastructure spend in India, so that is one sector where we’ll probably see more activity and better returns. Paul talked about new energy in China, and that’s one segment where we’re seeing a lot of activity. The regulators are very focused on getting it going. So, you’ll continue to see activity from there.

Infrastructure in Indonesia, energy in Indonesia, commodities are coming back. I think those are the areas the market has focused on.

IFR ASIA: Thank you. To wrap up, if I can get you to put your prediction hats on. Throw it forward 12 months, what do we think Asian credit is going to look like?

AVINASH THAKUR, BARCLAYS: In my view, at the end of December 2018, we’ll be very close to where we were in December 2017.

PAUL CARRETT, FWD: I think rates will end up around the 3.20% mark by year end. It’s going to be a pretty interesting ride. I wouldn’t call it a year of living dangerously, but it could be pretty volatile. There will be opportunities to pick up some interesting assets and to play some cross-currency basis games along the way.

As for how that feeds into issuance, the demand from the supply side is there, so I’m with the consensus on the actual supply side. It will be a fun journey, I’m sure.

DESMOND HOW, GAOTENG: I think we’re still in the last phase of a bull cycle. Macro events out there are not catastrophic enough to cause a turn this year. So, I will predict spreads to tighten. Right now the JACI is at 228bp, and we’ll probably see that tighter over the year. Long rates are anchored around 3% and the rating trajectory should be positive as we’re now seeing synchronised growth – as Michael said.

I’m pretty constructive. I think we can go down the curve to maybe the frontier economies to pick up some extra yield, but I am cautious about the timing of entry. I think this year will be marked by a few bouts of volatility and you’re going to have to pick your spots.

PAUL AU, CMBI: My view is you’re probably going to see a bit more supply. I’ve been telling people to expect US$325bn, so a 5%-10% increase from last year. I think 10-year rates are probably going to go beyond 3%. If you look at credit spreads, I do think it’s going to compress this year, just because people will be chasing yield, and as a result people will be putting a lot of money to work.

IFR ASIA: You’re going to be even busier. Very good. How about you, Cliff?

CLIFF TAN, MUFG: Well, maybe I’m just saying this because I don’t have a dog in this fight, but I’m more bearish on rates. We haven’t talked about it yet, but I’m expecting the US fiscal deficit to blow out a bit and to easily hit US$1trn in the next fiscal year. I can see the 10-year higher than what Paul is saying by the end of the year, if we get the four hikes.

We had a very uni-directional year for currencies in 2017, but I just really find it very difficult to believe that we’re going to have a second uni-directional year. There’s going to be some interesting volatility.

I think Trump is going to be worse than expected. I think his execution on policy is going to be worse than expected, because the quality of people around him is going down. And so the market is going to keep pushing this weak dollar story. But I would predict at least two significant dollar rebounds during the course of the year, just because that trade is so crowded.

China seems to be doing some possibly positive things in terms of dealing with its troublesome debt problems. Since the Party Congress, trend credit growth has slowed down, that’s for sure, but we don’t really know what’s going on with the (SOE) restructuring. If it’s positive, I’m going to turn more positive on China later in the year. But if it’s just more refinancing, our prediction has been that credit troubles will re-emerge in the second half of this year. I’m talking about credit spreads in China widening back to wider than they were in the second half of 2017.

MICHAEL TAYLOR, MOODY’S: Well, I’m in a slightly unusual position here. I’m usually the bear in the room! I think we are late in the credit cycle, but we’re not at the end of that cycle yet. We’ve been talking about how this is a slightly extended cycle because of policy and QE, and I suspect for most of this year we are still going to see a continuation. There will be more volatility, I think, as the year goes ahead. But I doubt if it’s going to be sufficient really to derail the fundamentally benign scenario that we expect for 2018.

We don’t have any kind of projections on issuance, but I think we will continue to see quite strong volumes this year. Some of that is down to China. If credit conditions domestically remain as tight as they are at the moment, we’re going to see more offshore issuance throughout the year.

We have predominantly stable outlooks across the Moody’s rated portfolio. Negative outlooks peaked at the beginning of 2016, and they’ve been on a downward trend ever since. For 2018, our outlooks are basically stable across the great majority of the portfolio. So, again, I don’t really see a big change there.

Like Cliff, I tend to see the glass half empty. Part of my role is to remind my colleagues of the downsides, and I think it is worth keeping in mind that the volatility story could be greater than we anticipate in our baseline projections. That could then start to have some real economic effects.

Protectionism could become a rising risk this year and I think that would disproportionally affect Asia. Politics do play an increasingly important role, and we have to be increasingly conscious of the political risks and the risks of policy change. Will those downside risks materialise during the course of 2018? I’m not sure they will, but I think if we gather around this table in 12 months’ time, some of those downside risks may be a bit more apparent as we look out at 2019.

IFR ASIA: It sounds like we have an interesting year ahead! Gentlemen, thank you very much for your insights. 

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