As developed market central banks repressed rates in response to the financial crisis, and then Covid-19, traditional risk assets rose to record highs. This beta driven market forced investors into unfamiliar territory in the search for yield, says Arthur Lau, co-head of emerging markets fixed income, PineBridge Investments.
One such area has been Asia fixed income, which has become an increasingly prominent part of institutional investor portfolios. However, as with any major policy shift, the first US rate hike since 2016 is likely to set off market volatility. While investors may have already processed this possibility, the challenging part remains: how to position for this pivot?
A rising rate tide is unlikely to lift all boats - some fixed income sub-asset classes will do better than others - and therefore, differentiation is key. For investors with greater flexibility to navigate the global fixed income markets, Asia bonds offer a differentiated risk profile that make them valuable and timely holdings to insulate global portfolios from these risks.
Duration, duration, duration
The longer the bond's duration, the more its value is likely to fall as interest rates rise. Therefore, holding shorter duration bonds helps lower the volatility of bond prices in a portfolio. For this reason, overweighting short duration is one of the primary strategies to mitigate interest rate change risk.
Asia bonds offer the advantage of shorter duration compared US and Global Aggregate peers, both in the investment grade and high yield segments.
For example, Asia IG has approximately three years shorter duration than US IG, but offers incremental yield. Similarly, a comparison of US HY and Asia HY highlights the latter's shorter duration, but with nearly double the yield.
This higher yield/shorter duration profile potentially offers wider room for spreads to tighten and help absorb rate changes. Active duration management at the portfolio and security level, adjusted according to the direction of interest rates, should minimize the risk of erosion in bond values and potentially enhance returns.
US Treasury correlation has been historically low
Over a medium to long term, we believe the rising rates cycle will have moderate impact on Asia credit. Over the last 10 years, Asian investment grade bonds have proved to be only moderately correlated to interest rate measures, while Asian high yield bonds are negligibly correlated.
Credit spreads for the high yield sector continue to trade at historically wide levels due to ongoing concerns within the China property space. But with ultra-low correlation to US Treasury, the wider credit spreads within the segment should provide a buffer to offset the rise in interest rates.
The advantages of duration management and low correlation could be amplified by selecting the right companies to invest in. Credit metrics is steady for Asia corporates - leverage has shown a stable trend over the past five years and liquidity of the issuers is on an improving trend.
Fundamentals for corporates in Asia are expected to remain strong on the back of an anticipated broader macro recovery in the region. We believe this will be a supportive environment for a spread tightening bias against US bonds.
The US dollar Asia IG market, for instance, has grown to nearly US$1 trillion in market capitalization and offers a diversity of high-quality issuers (average credit rating A-) beyond China, including emerging markets such as Indonesia and the Philippines, as well as developed economies like Singapore, Hong Kong, and South Korea. The significant presence of quasi-sovereigns is a key characteristic of the market unlike its peers.
Addressing challenges in the property sector
Similarly, like the IG market, Asia HY has gone through some rapid expansion in recent years. Despite the positive fundamentals, Asia high yield continues to remain under pressure as distressed situations weigh heavily on market sentiment, particularly in the real estate sector following Evergrande's ongoing issues.
We believe the sector has been oversold. The Chinese government is fully aware of the risks surrounding the property sector and have a variety of levers to pull to contain any potential spill over. Indeed, the approach being taken towards resolving Evergrande's issues forms part of longer-term strategic economic changes in China.
These include reducing the role of the property sector and encouraging the country's large savings base to switch into productive assets.
The conflict in Ukraine
We continue to monitor the situation in Ukraine. We have not seen much direct impact with regards to Asian economies and Asia bonds given trades from Asia to Ukraine are not significant. We do not expect a material, direct impact to the banking systems, corporate or economies to Asia region, though we are profoundly aware of the political and humanitarian impact of the conflict.
Corporate credit spreads widened in tandem with the global risk off sentiment, but in line with other markets. Initially, Asia IG and non-China HY bonds have been quite resilient.
Select commodities and energy related assets could see enhanced demand due to supply disruption. For instance, coal reached a record high recently, which has benefitted Indonesia's coal sector.
Over time, the policy shifts in China are expected to strengthen its economic foundations, benefiting the broader regional economy, while secular trends now taking shape should support the continued growth and deepening of the Asian bond market.
The potential protective benefits of Asia bonds in managing near-term risks such as rate hikes and inflation together with its long-term prospects make it a solid asset class to hold today and for years to come.
By Arthur Lau, Co-Head of Emerging Markets Fixed Income, PineBridge Investments