A CHANGING LANDSCAPE
The recovery in Asia high yield (HY) spreads that started in the second quarter continued into the third quarter. However, sentiment stalled slightly in September as headlines about the US election and a second wave of COVID-19 infections moved across Europe. Despite short-term volatility, we believe the trends that supported the recovery will continue through year-end. Specifically, we expect central bank policies to remain accommodative well into 2021, prolonging a low-yield environment that should support demand for spread products. While markets remain optimistic that a vaccine in 2021 will usher in a return to normalcy, we believe the pandemic will leave a lasting impact on the investment landscape. However, until we are past the pandemic period, we cannot begin to fully assess the potential lasting impact on economies. We believe Asia, anchored by China, is better prepared to overcome the pandemic-related growth challenges. We also view Asia as better positioned to navigate the rapid changes spurred by the COVID-19 response. Stronger growth prospects coupled with the chase for yield supports a constructive demand backdrop for Asia HY credit, which we believe offers an attractive carry opportunity.
RECOVERY UNDERWAY IN CHINA
Led by swift policy response, activity in China rebounded surprisingly quickly. Loose monetary and fiscal policy contributed to broad infrastructure investment. Real estate activity was quick to rebound as well. A theme of supply chain repurposing (for PPE- and WFH-related exports) was evident in the data, supporting both exports and manufacturing investment. Production was quick to recover, but consumption was patchy and lagged as the labor market remained weak. That said, as restrictions have continued to ease, the service sector has been improving, although it is still below pre-COVID-19 levels in areas such as domestic travel. Nevertheless, leading employment indicators have started to turn and will likely be supportive of consumption going forward. Strong credit growth will likely sustain through year-end, but we believe the growth impulse will soften. We expect this should support infrastructure spending for at least the next six months. We also expect the growth impulse will shift to other areas of the economy. An improvement in industrial profit growth and new orders to inventory is generally a positive for “animal spirits.” Trade indicators also point to sustained strength in exports.
BROADER ASIA SOMEWHAT MIXED
Looking at the region more broadly, Asia has bookended the spectrum with regards to COVID-19 containment. North Asia, Singapore and Thailand have done well to contain the spread of the virus and activity in these regions has started to rebound to varying degrees. Meanwhile, the Philippines and India are facing challenges arising from poorer healthcare, higher population density and lower GDP per capita. Movement restrictions, however, have helped to curb the spread and we have seen emerging signs of improvement.
In frontier Asia, optimism around a possible IMF program lifted Sri Lanka bond prices, which faced extreme selling pressure in the wake of the COVID-19-induced recession. The spread of the virus dealt a blow to the country’s vital tourism industry, leading to multi-notch downgrades in the third quarter. We continue to prefer more defensive positioning here given the country’s challenged debt profile and weak growth.
FUNDAMENTALS IN ASIA HY CORPORATES
Assessing the impact on credit fundamentals, it is clear that COVID-19-related lockdown measures hit metrics in the first half of 2020. Within the Asia corporate space, HY deterioration outpaced weakness within the investment grade (IG) segment. Within IG, net leverage remained flat while HY leverage trended higher by 0.7x. Despite the worsening of leverage metrics, interest servicing and liquidity have remained intact.
Importantly, over the third quarter we observed stabilizing and improving trends, which we believe could continue through year-end. Moreover, we believe default rates should remain in check. Year to date, the Asia HY default rate is a moderate 2.3%; the full-year 2020 JPM Asia credit HY default rate was recently reduced to 3.0% from the prior 4.0% projection, a level far lower than developed market peers.
SIGNS OF STABILIZATION IN RATINGS TRENDS
We have seen signs of stabilization following a period of downward rating pressure late in the first quarter and early in the second quarter. The pace of downgrades abated in the third quarter, supported by lower rates and government support measures that helped offset the slump in selected sectors. While we see economic divergence in Asia, we believe we are past the peak in downgrades, although there is potential for further negative action in the sovereign, leisure and gaming sectors.
TECHNICAL FACTORS
Market technicals appear supportive of the Asia HY space. Based on expectations, net financing could hit a five-year low by the end of this year. The limited net new supply paired with a prolonged low-yield environment will likely make the spread premium offered by Asia HY credit attractive to investors. Broadly, investors outside Asia have increased participation in the Asia primary market, taking up 25% of new issues in September, up from 20% over the past four years.
VALUATIONS
Historically, low rates tend to pull down absolute yield levels. However, spread levels remain attractive on both a historical and relative basis at this time. The yield on the HY segment of the JP Morgan Asia Credit Index is close to 8%, well above the five-year average of 6.8%. Within the corporate sector, we are less constructive on broad-based beta and see more value in credit selection based on the retracement off the March wides. Additionally, if we compare Asian HY spreads to US HY spreads, the additional spread premium appears attractive, especially when considering lower default expectations out of Asia.
RISKS
While macro-related headlines may drive volatility in credit spreads, spread levels remain attractive within the Asia credit space. Risks to our base case view include worsening disruptions from COVID-19-related containment measures, a resumption in the US/China technology trade conflict, and exacerbated funding challenges for low-rated sovereigns.
Key Investment Risks
Credit Risk, Issuer Risk, Liquidity Risk, Interest Rate Risk, Non-U.S. Securities Risk, Currency Risk, Derivatives Risk (for portfolios that utilize derivatives), Leverage Risk (for portfolios that utilize leverage), Counterparty Risk, Prepayment Risk, Extension Risk, Equity Risk, Non-Diversified Strategies.
Disclosure
This material is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only, and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted and actual results will be different. Information obtained from outside sources is believed to be correct, but Loomis Sayles cannot guarantee its accuracy. This information is subject to change at any time without notice.
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Market conditions are extremely fluid and change frequently.
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