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Thursday, 18 April 2019

Will the music stop?

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2012 broke all the records when it came to bond issuance, but signs that investors are shifting back towards equities are especially worrying for Asia. What’s next for Asian credit?

World-renowned violinist Itzhak Perlman rehearses with a local symphony in the southern Chinese city of Guangzhou.

Source: Reuters

World-renowned violinist Itzhak Perlman rehearses with a local symphony in the southern Chinese city of Guangzhou.

The first few weeks of the year may have carried on where 2012 left off, but consensus has it that Asian credit’s record run is nearing its expiry date. The bumper returns on Asian bonds will be hard to repeat, and global investors are already turning their attention to equities.

Asia debt had a record year in 2012. Not only did the volume of new dollar bond sales surpass any previous year – and by some margin – but the region’s main credit benchmarks also notched up their best performance in years.

Asian issuers, excluding Japan and Australasia, sold US$134bn of bonds in dollars, euros and yen, making 2012 the best year on record for arrangers of new issues by some distance. The iTraxx index of Asian investment-grade CDS surged from 200bp on January 1 to 109bp by the end of the year. High-yield bonds gained, too, helping investors chalk up gains of 50% or more on their Asian portfolios.

Especially striking was the outperformance of Asian credit relative to equities. By the end of August 2012, a bet on the MSCI Asia ex-Japan equity index would have returned less than 6% since the start of the year, versus 25% on the iTraxx index of investment-grade debt. IPOs struggled while orderbooks on new dollar bonds soared.

Bond specialists have been quick to declare that Asia has finally come of age, with the surge in volumes making the region an integral piece of the global debt capital markets for the first time. For others, however, this temporary phenomenon has already run its course.

“We believe that 2013 could be a significant year, marking the reversal of trends, most notably the comeback of equities,” said Gary Dugan, chief investment officer for Asia and Middle East at Coutts, the private bank. “There is a step change: bonds are no longer the safe-haven asset they were perceived to be. As bond valuations reach extreme levels, we are mindful that investors run a real risk of losing money.”

At first glance, little has changed in the early part of 2013. Bond issues are still racing ahead, with January heading for a record monthly total. But the dynamics are very different.

The driving force behind Asia’s record credit year in 2012 was a reluctance among global investors to take any real risk. For most of 2012, the consensus trade was all about income: global growth was a distant dream and even the investors who kept faith with the equity markets preferred dividend stocks or real estate trusts.

This year, however, has started very differently. The star performers in the primary credit market have been almost exclusively below investment-grade, with high-grade borrowers noticeable largely by their absence. Equity indices have roared ahead, with the Dow Jones Industrial Average and FTSE each adding 6% in January. Hong Kong’s Hang Seng index gained 4.5%. Those stood in contrast to the US Treasury market, where the five-year benchmark backed up from 0.72% to 0.86% in January and the 10-year mark edged closer to 2% – its highest since April 2012.

HSBC’s latest survey of the world’s biggest global funds revealed 75% of fund managers were overweight equities in the first quarter of 2013, up from 40% in the fourth quarter of 2012. No fund manager held a positive outlook on bonds for the first quarter, while over a third were underweight in bonds.

The great rotation

January’s numbers paint a picture of far greater appetite for risk in the global markets than at any point in the previous 12 months. That is borne out in the primary markets, where Asian issuers have been able to sell Triple C rated dollar bonds for the first time and high-yield offerings have attracted jumbo oversubscriptions.

While that is good news for Asian issuers – especially the lower-rated ones – it is also cause for concern. A gradual switch away from defensive fixed-income investments and towards growth-dependent equities may pose little immediate threat, but trends catch on quickly in the capital markets, and bankers are wary about the effects of a rapid reversal.

“There’s a lot of leverage that’s been fuelling this credit rally. If rates reverse and that disappears, we could be in for a rough ride,” said one global head of investment banking.

Attention is already turning to the unwinding of public sector stimulus in Europe and the US. Early repayments of the European Central Bank’s LTRO funds have already exceeded expectations, effectively withdrawing more money from the sovereign and agency debt market. Sooner or later the US Federal Reserve will have to end its quantitative easing programme and think about raising interest rates – whether its hand is forced by economic growth or by inflation.

The Treasury sell-off was gathering pace towards the end of January thanks to bullish comments from the Davos World Economic Forum on the state of global growth, together with an unexpected high volume of early LTRO payments. For now, that move has been positive for Asian credit spreads, but investors who have not hedged out the rate risk are likely to find their returns under threat.

Return to risk

The return to risk poses some unique challenges to Asia.

The region’s historical preference for equities over fixed income is well known, making the risk of a full-scale switch out of bonds very real. That risk is even more pronounced after an unprecedented spree of bond-buying from Asia’s private banking clients in 2012.

Many of last year’s new dollar issues out of Asia came with allocations of 40% or more to private banks, responding to demands for income-generating investments. Those orders often came with high amounts of leverage, allowing investors to boost their returns on even a 3% investment-grade coupon to something far more attractive. The low borrowing rates that helped fuel that fire, however, cannot last forever, and the eventual unwind is sure to weigh on technicals.

Private banks such as Coutts are already recommending their clients switch from bonds to equities.

“The outperformance of emerging-market bonds reflects the thirst for yield and the recognition of the improvement in the credit quality of emerging-market debt,” said Dugan. “However, if appetite for risk picks up, as we believe it will, then we would expect a switch from emerging-market bonds into emerging equities.”

Fund flow data show that shift is already happening. In the week to January 10, for instance, emerging market equity funds recorded inflows of US$7.4bn, nearly four times that for debt funds, according to funds tracker EPFR. Asian bond funds are still attracting inflows, but have been doing so at a slower pace than equities since November.

Asian companies also have a poor track record when it comes to managing their way through the credit cycle. Investors have largely forgiven the many companies that defaulted on their international obligations in the wake of the Asian financial crisis over a decade ago, but in many countries their ability to recover investments in a workout is still untested. China, for instance remains a market full of contradictions: while domestic lenders are often forced to take losses to help repay domestic bondholders, international bondholders have routinely lost out to local banks.

While the global hunt for yield is helping Asian companies finance their growth plans, it is also adding to the risks on investors’ books as they move further into speculative territory. Corporate governance scandals involving Chinese companies, for instance, have burned both debt and equity investors in recent years, but bond buyers have been far quicker to forget the likes of Sino-Forest. US equity markets remain all but closed to Chinese issuers, while PRC property companies have accounted for the lion’s share of new issues out of Asia so far this year.

As if to underline those risks, the red-hot high-yield market is allowing previous defaulters to return to the international arena, such as Indonesian tyre maker Gajah Tunggal. After restructuring its debt four years ago, Gajah returned with a US$500m five-year non-call three in January at a yield of 7.95% — tighter than initial expectations.

The picture is also complicated at the macro level. As global investors grow more confident, Asian currencies are likely to face more upwards pressure – leaving policymakers hard pressed to keep their countries’ exports competitive without resorting to capital controls. While Asia has been willing to let currencies appreciate, the risk of currency wars cannot be ruled out.

None of that, however, is stopping yield-hungry investors. With no concrete signs that US rates are set to rise in the near term, bond buyers are happy to embrace risk in return for fixed returns. The chase for yield has pushed the average return in the US high-yield market to below 6% for the first time on record, and the lower borrowing costs are luring more Asian issuers to take advantage of ultra-low funding costs.

More than 20 dollar bonds came to market with no investment-grade rating so far this year, accounting for more than US$11bn of the US$17bn issued in Asia ex-Japan and Australia.

The stage is set for a great rotation from bonds to equities but January’s crop of new issues show that, in Asia at least, that trend has yet to get going. 

To see the digital version of this report, please click here.

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