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Important Disclaimer: The information made available in this article is meant for information purposes only. Such information does not constitute financial or investment advice. You will not rely on the information in this article in making any decision with regard to your finances or investments. We do not undertake or represent to any person to ensure the correctness and completeness of any information or data, nor to update them for currency with the passage of time. Our analyses, opinions and views are subject to change without notice, and we do not undertake or represent to any person with regard to their correctness, completeness or currency. Past performance may not be an accurate or complete indicator of, and does not guarantee, future performance. We and/or our immediate family members may or may not have previously bought or sold the securities mentioned in the article below.

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Introduction

More than a year ago in Apr 2020, we wrote about the attractiveness of US High Yield Bonds (see article), when credit spreads had widened past 8%. Since then, credit spreads have tightened to 3%, resulting in a 19% return for US High Yield Bonds.

Today, we see value in hard currency Asian High Yield Bonds. At the Index level, credit spreads are at 9.4%, closing in to levels seen during the peak of the Mar-2020 Covid-19 sell-off and the 2011 European Debt Crisis, where credit spreads had topped out at 10-12%.

Historical backtesting implies >8% per annum returns over the next 1-3 years from current entry levels. However, compared with past Asia High Yield Bond sell-offs, the outcome for this occasion looks to be more binary (and hence riskier) given that the sell-off has largely been confined to the China Property Sector, Macau Casino Sector and Sri Lankan Govt debt.

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Article Summary

1) Why have Asian High Yield Bonds been falling

2) Are current valuations attractive?

3) Default rates could rise to double-digit percent this year

4) Backtesting implies >8% p.a. returns over next 1-3 years

5) Ways to get exposure to Hard Currency Asia High Yield Bonds

Appendix 1: Bond issuers within Asia HY Index trading under 90 cents

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1) Why have Asian High Yield Bonds been falling

The USD Asian High Yield Bond Index has declined by 9% since the start of 2020, massively underperforming other risk assets. We attribute the decline to 3 key reasons – China Property, Macau Casinos and Sri Lankan Govt Debt, which comprise 35%, 6% and 4% of the Asia High Yield Bond Index respectively (China Property had a much higher weightage of 46% at the start of 2020, before the sell-off!).

On China Property:

• In 2020, the Chinese Govt put in place restrictions for developers (liquidity and debt ratios termed the “Three Red Lines”). A property developer which fails to meet all three of these ratios would not be allowed to increase its borrowings in the subsequent year, while meeting more of these ratios would allow a developer to borrow more.
• The Chinese Govt has also been trying to cool speculation in the property market, introducing various measures such as capping bank lending to developers, setting reference prices for property sales, raising mortgage rates, slowing the pace of mortgage approvals etc.
• To meet the “Three Red Lines” requirements, many property developers started to delay payments to their suppliers, and use the working capital to pay down debt instead. However, suppliers started to complain, raising concerns that some property developers were carrying off-balance sheet debt (e.g. trade payables owed to suppliers).
• Some of the more indebted companies faced problems trying to refinance their debt, i.e. China Fortune Land defaulting on its debt earlier this year (source: Caixin Global).

On Macau Casinos:

• On 14th September, the Macau government announced that it would be conducting a 45-day public consultation on gaming legislation, which is expected to step up scrutiny of operators in the world’s biggest gambling hub. This comes ahead of Macau Casino groups’ 20-year concession expiry next year.

• Investors are concerned if Chinese regulators would take a heavy-handed approach, as it has done with tech, online gaming and private education.
• The impact from Covid hasn’t helped, with gaming revenues still down ~80% from pre-pandemic levels (source: FT)

On Sri Lankan Govt Debt:

• On 27 Aug 2021, S&P Global cut Sri Lanka’s CCC+ sovereign rating outlook to negative from stable, warning the government may find it increasingly difficult to finance itself over the next 12 months. (source: Nasdaq)
• Debt-to-GDP levels exceeding 100%, more than 80% of government revenues going on interest payments alone and foreign exchange reserves dropping to less than two months import cover in July have raised the probability of bond default (source: Reuters).

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2) Are current valuations attractive?

Here’s the historical credit spread for USD Asian High Yield. To recap, credit spreads are simply the extra yield you get for buying a corporate bond (over a risk-free govt bond).

Right now, credit spreads are at 9.4%, closing in to levels seen during prior crisis periods (Mar-2020 and the 2011 European Debt Crisis), where credit spreads had topped out at 10% – 12%.

Relative to US High Yield, USD Asia High Yield is trading at its cheapest level in the last 10 years. USD Asia High Yield trades at a 6.6% credit spread premium over US High Yield, extremely elevated relative to the historical 1.1% credit spread premium.

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3) Default rates could rise to double-digit percent this year

While there is definitely elevated near-term risk, we believe it has already been more than priced in. Historically, default rates for hard currency Asian High Yield Bonds have averaged around 3% per annum, and peaking at 9% in 2009 (see chart below).

Think of it this way.

• At the Index level, the current yield-to-worst for USD Asia High Yield Bonds is 10%.
• Assuming: 1) bonds are all trading at par value, 2) defaulted bonds offer a 20% recovery value, 3) there are no changes in interest rates or credit spreads over the next 1 year
• This implies that default rates can hit 12.5% before an investor loses money (10% yield divided by 80% loss-on-default).

For those who follow Evergrande closely, here’s a theoretical point to take note of. If Evergrande defaults, the default rate for USD Asia HY Bonds would jump from 3% to 14%.

However, for the purposes of new investors buying into the bond index now, this does not really matter as much. This is because with Evergrande bonds trading at ~20 cents on the dollar, its index weight has correspondingly declined to 2.1% (limiting an investor’s downside). Furthermore, recovery values in a default scenario is expected to be around current market prices, according to analysts across JPM, Goldman, Bank of America among others.

Given the above considerations and a view that the Chinese Govt will look to control any contagion to the broader property sector, our own view is that current valuations compensate investors enough for the credit risk.

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4) Backtesting implies >8% p.a. returns over next 1-3 years

We ran some backtests to calculate the type of returns you’d have gotten across 6-month, 1-year, 2-year and 3-year horizons, had you invested in the Index when credits spreads first hit 7% across various time periods (results in table below). This errs on the conservative side since current credit spreads are higher at 9.4% – we wanted to add a margin of safety since the outcome this time around is going to be more binary.

Results: Investing in USD Asian High Yield Bonds when credit spreads widen to 7% would historically have earned returns of >8% p.a. over the next 1-3 year period.

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5) Ways to get exposure to Hard Currency Asia High Yield Bonds

We shortlisted three ways to get exposure to USD Asia High Yield Bonds. They have been selected based on:

• Availability on platforms that SG investors have easy access to
• Investable in either USD and SGD
• Other factors such as cost-efficiency, track record etc

For more details, one can check out the individual ETF/fund websites listed below.

• iShares USD Asia High Yield Bond ETF: This ETF tracks the Bloomberg Asia USD High Yield Diversified Credit Index, which is what the credit spread charts and backtest earlier was based on. The ETF may be purchased via most stock brokerage accounts that allow for SGX access.
• Fidelity Asian High Yield Fund: Cheapest way to purchase this is via Dollardex or POEMs.
• Pimco Asia High Yield Bond Fund: Cheapest way to purchase this is via Endowus Fund Smart, as the platform rebates you 0.7% of the fund’s TER, so your all-in TER would be 1.15% (0.85% + 0.3% Endowus management fee).

Our preference: We personally purchased the Pimco Fund, since we think there’s potentially some inefficiencies in the high yield bond market that active managers can capitalize on. And it’s slightly more cost-efficient when buying through Endowus.

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Appendix 1: Bond issuers within Asia HY Index trading under 90 cents

Doing a look through to the Bloomberg Barclays Asia USD High Yield Diversified Credit Index, there are a total of 182 bond issuers within the Index, and only 19 are trading below 90 cents on the dollar. We have highlighted the property sector bonds in light orange.

This supports the view that the sell-off hasn’t been broad-based and investment results will likely be driven by whether there are positive outcomes to the below list, and assuming limited contagion spillover to the broader asset class.