Analysing the Case for Asia Credit Bonds

In this Insights note, we look at some of the key features of Asia credit bonds, defining the asset class as the universe of U.S. dollar or other hard currency denominated bonds of Asian issuers, both corporate and sovereign, but excluding Japan. We view Asia credit bonds as an exciting, relatively new asset class with sound long-term prospects predicated on strong regional economic growth. An allocation to Asian credit can act as a diversifier within global fixed income portfolios. When compared to regional equities, the corporate segment can also be thought of as providing a more defensive, less risky way for investors to access Asia's high economic growth.

Advantages of Asia Credit Bonds

Scale: The first advantage of Asian credit bonds is that they possess significant scale, having grown into a universe that is too big for global bond investors to ignore. Today, the Asia credit bond market consists of around USD1.1 trillion of outstanding bonds (as of March 31, 2022). In terms of size, this is roughly comparable to some of the more mainstream global fixed income sectors. For example, the U.S. high yield market – a segment often thought of as mainstream – is only a little larger, with some USD1.5 trillion of bonds outstanding (as of March 31, 2022).

So the Asia credit opportunity today is broadly comparable in terms of magnitude to that offered by U.S. high yield. Importantly, we have reached today's scale via healthy growth in the volumes of Asia credit over the past decade, where annual growth has averaged about 15%. So this is a fixed income market that has experienced significant growth over time. This has led to a corresponding increase in the breadth and the depth of the opportunities available to investors in Asian credit bonds.

Return: The second key advantage of Asian credit bonds concerns prospective returns. Currently, global investors receive a yield pickup that looks quite attractive versus U.S. and developed credit markets, and also versus global aggregate benchmarks. The average yield for Asian credit bonds is running at 4.8% today, delivering a spread of around 265 basis points over the yield on global bonds.¹ At the same time, we view investors as gaining access to a region where there is still good long-run growth potential that over time can translate into improving credit profiles and lower spreads.

Risk: The third factor supporting Asia credit bonds concerns the risk profile. Out of the emerging market fixed income universe, our analysts characterize Asia credit as belonging to the higher quality segment. The ratings profile is one feature that shows this higher quality bias. Asia credit bonds have an average investment grade rating and almost 80% of the bonds in the universe are rated investment grade.²

Inefficiency: A fourth supportive factor is inefficiency. Within Asia credit there are informational asymmetries in the market. This can benefit active managers who can navigate these market inefficiencies and identify 'alpha' with a process that is centred around fundamental credit and fixed income research. So ultimately, we believe there is a compelling risk-adjusted potential return opportunity for Asia credit bonds within the overall global fixed income context.

One of the key selling points for Asia credit is that historically the asset class has generated attractive risk-adjusted returns. This is particularly true for the investment grade (IG) part of Asia credit, which is about 80% of the opportunity set. This attractive risk/ reward combination can be seen clearly in Figure 2. Over the 10-year period to 31 March, 2022, the Asia IG sector has delivered a similar long-term return to U.S. investment grade, but it has done so with significantly less volatility.

To illustrate this point further, we looked at past periods of global market volatility where IG bond spreads around the world were widening (Figure 3). We found that Asian investment grade bonds in these periods generally held up well against their developed market peers, widening less than or similar to U.S. and European investment grade bonds. A good example is the sell-off that occurred during the peak of the coronavirus pandemic in 2020. Then, Asia IG spreads actually widened about half as much as U.S. investment grade corporate bonds.

To summarize, Asian credit is an asset class that has provided a spread pick-up over U.S. investment grade bonds, but which in periods of global market turbulence has behaved in a fairly similar manner though with with less duration and interest rate sensitivity. We think this is an interesting combination to add to any global fixed income portfolio.

Asia Credit Bonds and Responsible Investing

Environmental, Social and Governance (ESG) considerations are an important part of our approach to investing in Asian credit. This is increasingly important to investors around the world. The ESG dimension is particularly critical in terms achieving investment success in Asia. At T. Rowe Price, we believe that integrating ESG into our process can help us to build more resilient Asian bond portfolios.

On the environmental side, Asia is quite clearly starting the race from the back of the starting grid. We carried out a study of global fixed income benchmarks and found that Asia credit has the highest carbon intensity. This partly a function of high growth and high energy intensity, accompanied by above average reliance on fossil fuels such as coal. In Asia, bond issues tend to be skewed toward more commodity and energy-intensive industries. On the positive side, we are seeing a stronger response among the companies we monitor to the market's demand for progress on environmental initiatives, as well as better disclosure. As an example, more of the companies within our portfolios are reporting their carbon data, over 50% compared to around 20% in 2020.

Among ESG screens, in Asia we are seeing greater attention than before to the social side. For example, we have seen a spate of regulatory actions in China over the course of the past year linked to Beijing's goals for financial stability and social objectives, such as more affordable housing, reducing the education cost burden for families, and achieving a more equitable sharing of the revenues from internet platform companies with their employees and their vendors. All of these factors have become very important to valuations are a clearly critical consideration within the research and investment process.

In our Asia credit bond portfolios, we want to reflect key ESG considerations by design, excluding companies and sectors that have higher ESG risks than we are comfortable with. So in the portfolio, there are three things that we must do. The first is to integrate ESG considerations into all of our fundamental credit research and into the decision- making process for credit selection. Our credit analysts work with T. Rowe Price's dedicated ESG specialists to study those factors they feel are material to changes in the credit profile.

The second thing we do is to adopt minimum standards for ESG ratings derived from our proprietary model, the Responsible Investing Indicator Model (RIIM). The model scores every owned issue with either a green, orange, or red rating. The RIIM model is managed by T. Rowe Price's ESG specialist team and combines data from external vendors as well as our own proprietary analysis. The last thing we do is to implement T. Rowe Price's proprietary Responsible Exclusion List. We maintain an exclusion list of companies that responsible investment products cannot invest in, mostly guided by their involvement in certain undesirable activities. Within an Asia credit bond context, the most common exclusions relate to coal production and gambling.

Views On China's Property Sector

The property sector is a meaningful part of the China segment. As such, the selloff that began last year has had a significant negative impact on overall returns for the Asia credit asset class. To take a step back, what has happened in China's real estate sector really boils down to the policy objectives of the Chinese government. Their aim in recent years has been to deleverage the real estate sector and, from a social perspective, to maintain a more stable house price environment ('houses are for living in, not for speculating'). Coming out of the coronavirus pandemic in 2020 with a strong economic rebound, Beijing introduced measures to tighten funding and restrict capital access to property developers and also dampen housing market enthusiasm. As a result, many developers came under strong financial pressure, with Evergrande the first and most famous example.

Beginning in late 2021 we saw defaults by developers in the Asian bond market that far exceeded our and the market's expectations. Funding access became incredibly tight, with much stricter control of escrow accounts for presales revenues, for example. Banks also cut back on their lending to developers, while presales, starts and home sales fell sharply, creating a negative spiral and a loss of confidence among home buyers. Chinese policymakers were willing to accept a greater degree of pain in the property sector before they would consider compromising on their long-term objective of deleveraging to reduce systemic financial risk.

In the past, the playbook on China's reforms has often been characterized by two steps forward followed by one step back and a bit more stimulus. But in the case of residential property, Beijing took many steps forward on the reform path before conceding one step back. The financial pain from the reforms was concentrated almost entirely in the offshore HY U.S. dollar bond space, with few other asset classes being directly impacted. As other asset markets started to show more turbulence, we have begun to see a more decisive policy easing response from the government, including from the central bank, the People's Bank of China.

In terms of the outlook for the China HY bond sector, our analysts expect to see some further volatility in the short term, followed by a longer period of consolidation. Our expectation is that China's property construction industry will switch to a more utilitarian model, dominated more by state-owned developers, with private sector companies playing a smaller role. In the longer term, investors should welcome a healthier sector backdrop, with stronger balance sheets for those companies that survive the consolidation process. Despite the volatility in China's high yield property sector, the rest of the Asia credit bond asset class remained relatively resilient during the turmoil.

Asia Credit Market and the Coronavirus Pandemic

From an Asian corporate perspective the impact of the coronavirus pandemic has – as in other regions - been very, very uneven. Some sectors suffered much more than others, such as the gaming sector, airlines, tourism etc. Also pertinent is the fact that we still have a strict zero covid policy in place in mainland China and Hong Kong. In contrast, a lot of other Asian countries have begun the process of opening up and are 'learning to live with covid.' From an economic perspective, there has been a disproportionate impact on those Asian countries that are dependent on tourism, such as Thailand. Sri Lanka is one case where the drop in tourism revenues since 2020 has been a factor that has led to the stress of the sovereign balance sheet. The Sri Lankan government recently called on the IMF for advice on debt-restructuring that may lead to a potential default on the country's sovereign debt. 

More broadly, there has been a larger fiscal burden on Asian governments as they strove to support health care and economic activity in the face of the pandemic. Encouragingly, most Asian economies have shown an ability to weather the storm. Asian governments gained credibility for having more prudent fiscal management, building external buffers etc over the course of the past five to ten years. As a result, we have seen structural improvements in their macro fundamentals that have served them in good stead during the pandemic.

And at the corporate level, many of our Asian credit exposures are from countries that have investment grade credit ratings, with stable or positive ratings trajectories in recent years. In contrast to Asia, a number of emerging market economies in other regions, such as Brazil, South Africa and Turkey have transitioned from IG to high yield, which we think to be a move in the wrong direction for investors. Asia has held up relatively well in this respect and appears to be in a better position to withstand any further negative shocks, whether arising from the coronavirus or from other sources.