By Hamlin Lovell, NordicInvestor
Muzinich & Co. runs c. US$5.8 billion in emerging markets debt (as of 31 December 2019) of which roughly half is in Asia ex-Japan, a region that could be relatively appealing at present: “politically, the outlook in Asia is generally stable. Asia has had elections in 2019 and should not see contagion from emerging markets such as Argentina, Venezuela, Ecuador or Turkey. Xi Jinping will be in power for at least another 5 or ten years”, says Muzinich & Co. portfolio manager, Christina Bastin, who has been watching Asia for 25 years during which time China’s GDP has multiplied more than tenfold.
She makes regular trips to the region and views the macroeconomic backdrop for Asian credit as broadly positive in early 2020: China has gone through deleveraging which started in 2017 and peaked in mid-2018. This process addressed SOEs, shadow banks and asset managers, saw currency depreciation and a decline in trade with other emerging market countries. But the focus has now shifted from deleveraging to stablisation. The currency has steadied, the trade war has not hurt much as US exports are only a mid-teens percentage of GDP, and monetary policy is also not moving much now. Though the Chinese economy is still slowing, 2020 is the year when Chinese President, Xi Jinping, wants to show that he has doubled GDP since 2010, fulfilling one part of his ‘Chinese Dream’ goals and ideals. “The Government has revised 2014-2018 GDP figures already. Cynics might view this revision as opportunistic, but the fact remains that a lot of economic statistics are based on arcane measures of industrial production. The recent coronavirus outbreak has put a headwind to these growth targets, and we expect a meaningful slowdown in the first quarter. Nevertheless, we believe, through policy measures, the government is likely to steady growth for 2020”, says Bastin.
“In our view, Asian corporate credit still offers a meaningful yield pickup versus European and US corporate credit, and this is not a currency carry trade game based on some local currencies offering higher interest rates. We are investing in USD denominated paper, where the reference index – the Asian USD index (comprised of c. 85% investment grade and c 15% high yield) – yields c. 4% at 5 year duration whereas a comparable US index yields c. 2.9% at 7 year duration. For high yield, the pickup is c. 2%.² This has come down from 4% in late 2018 but is still attractive in our view. We are emphasizing credit risk and running lower duration than the index. Investment grade credit outperformed in 2019 partly due to its greater interest rate sensitivity but we expect high yield could outperform in 2020 if interest rates stabilize. Coupon income should be the main source of return”, she says.
The extra income is not necessarily an illiquidity premium: “the Asian USD market is a c.$1 trillion market that is second only to US corporate bonds for liquidity³. The market trades 22 hours a day, only pausing for Hong Kong’s ‘dim sum’ lunch break”, says Bastin. (The market size has grown to US$1,071 billion, per the JP Morgan JACI index analysis as of December 31st, 2019).
Though the asset class is relatively good value overall, Muzinich & Co. are not benchmark huggers and Bastin is mindful of heightened default risk: “we expect defaults could jump to 3% this year from 1% in 2019⁴, partly because companies did not default last year. Abundant liquidity has sucked in speculative issuers. We do not see any systemic risk and do not see downgrade risks for disciplined companies, but do expect a tail end of defaults. The high yield strategy may occasionally own some stressed, ‘B’ rated paper, but not defaulted, ‘CCC’ or ‘D’ rated names.”
Credit quality in the USD Asian credit markets is generally high. Bastin argues that, in her view, “the crème de la crème of Chinese issuers are those that come to the USD markets, with about half being ‘A’ rated. The market is mainly investment grade (AA or A rated) with some BBB rated ‘crossover’ names on the cusp of high yield”. So-called ‘Zombie’ companies surviving on rafts of state support would not be welcome”.
This risk profile matches her macro outlook: “in a slowing economy, we expect a flight to quality to the strongest, fittest and most strategic credits. We have substantial weightings in the two bastions of the Chinese economy: state owned enterprises and property. State conglomerates, majority owned by the Government, are widely perceived as ‘quasi-sovereign’ in terms of risk profile. Examples include the world’s largest electric utility, waste management firms and housing associations”. In the wake of the coronavirus, Chinese property names have sold off and we believe may now represent even better opportunities.
“We also like local provincial debt, including infrastructure-related bonds such as toll roads, which we believe will benefit from more extensive fiscal stimulus. Fiscal policy is firing on many cylinders: export tax rebates, infrastructure spending, corporate tax cuts and personal tax cuts. Strictly speaking, these bonds are not pure municipal government debt but rather corporations owned by local governments, and local government financing vehicles. These are short dated, investment grade, low volatility names, but can still offer some yield premium for BBB or A rated paper”.
“We also favour tier one banks and are not tempted by second, third and fourth tier banks. For yield pickup, we would rather go down the capital structure of a tier one bank and own subordinated debt issued by banks such as Bank of China and ICBC”.
Plenty of analytical resources are available to crunch the numbers. Bastin’s London-based team of four is supported by two analysts in Singapore and one in New York. There are also some synergies with Muzinich’s private debt business.
Country selection is also important in this climate. If China is well past its worst phase of the credit cycle, other countries may be only just beginning to face up to ‘bad bank’ problems. “India had its own credit crunch in 2019, which started with the collapse of a large non-bank financial institution, IL&FS, which has seen its board taken over by the Government. IL&FS was perceived as a safe, blue chip, 100-year old, AAA-rated name, so the default sent shockwaves through the market and froze up interbank liquidity. Since 2003, non-bank finance has substantially grown in the Indian financial system”. The rout has contributed to a slowing of economic growth to c 5%⁵, confounding the consensus amongst economists, which had been for India to grow faster than China.
Bastin is also avoiding Hong Kong for now as she fears it may lose relevance as a financial hub if companies move offices to Singapore, and anyway does not offer compelling value: some property related bonds may only pay as little as 3% on very long dated paper. “In our view, the coronavirus will only compound Hong Kong’s retail downturn in the first quarter. Considering these fundamentals, we believe being underweight Hong Kong is justified.”
Volatility has also created trading opportunities in some other emerging Asian countries. In late 2018, Muzinich & Co. made an opportunistic excursion into Indonesian debt, as Bastin was of the opinion that markets were overly pessimistic on the Indonesian Rupiah.
Muzinich & Co. already has an Asia credit mandate which follows the Norges Bank Investment Management exclusion list. In fact, “we could easily run the strategy as a fully ESG approach. We have no mining names, no palm oil and very little energy or fossil fuels. We are overweight clean energy, consumers, technology and finance. Our priority is to roll out ESG integration. Although we already look at ESG factors in our fundamental credit analysis, we need to continue to improve the process and make it more transparent. Our aim is to create the first fully ESG compliant liquid Asian corporate credit offering”, says Bastin.
Source: World Bank https://data.worldbank.org/country/china
² Source: Bloomberg as of February 17th 2019. Past performance is not a guide for future results.
³ Source: JP Morgan JACI Index as of December 2019
⁴Source: Bank of America Merrill Lynch.
⁵Source: Reserve bank of India. https://www.rbi.org.in/scripts/BS_ViewBulletin.aspx?Id=18762