Asia’s credit fundamentals are steady and improving outside of a few sectors and idiosyncratic situations, which should offer a strong foundation for the region’s fixed income market in a potentially choppy, policy-driven 2022.
Source: Data as of 30 June 2021. BAML. For illustrative purposes only. We are not soliciting or recommending any action based on this material.
We expect credit spreads to tighten in the next 12 months, with pronounced credit divergency alongside the expected increase in the number of defaults in 2021. The default rate is likely to rise to the low teens in full year 2021. However, we expect this to fall to single-digits in 2022. We view these defaults to be mainly idiosyncratic rather than systemic in nature, which calls for thorough credit differentiation.
Uncertainty from China’s policy reforms will be the major near-term source of volatility in the investment markets, while the impact from Covid-19 should ease more noticeably. Chinese policy reforms may be difficult to predict and this unpredictability may make it challenging to assess investment risk. The changes may also hurt the real economy, which is already showing signs of deceleration. We believe volatility will remains higher than the historical average for some time, although we expect it to subside gradually in next 12 months.
With Chinese high yield (HY) bonds accounting for over 50% of Asia’s HY bond market, the development of this segment will determine how the broader market will perform over the next 12 months. In the near term, we expect the Chinese property sector to remain under pressure as concerns about the sector’s liquidity and refinancing risks intensify, but we believe the government has adequate tools to contain any risk from this sector. That said, investors should put Chinese property developers that face significant near-term liquidity or refinancing pressures in a different bracket than other issuers.
An economic slowdown and ongoing policy reforms may pose risks while also creating opportunities, as potential policy easing and supportive measures may reverse the current defensive sentiment. At the same time, policy reforms will likely benefit sectors whose activities are aligned with the central government’s agenda.
Outside China, we are constructive on the commodity sector given the hefty credit buffer these companies have built in recent years from the surge in commodity prices. The credit matrix should have adequate cushion to absorb any slowdown in economic growth. Compared to the Chinese property sector, we think Asian commodities will be a more stable, lower-beta sector.
In contrast to the first half of 2021, we think the volatility in Asia’s investment grade (IG) market will ease in the coming 12 months given the overall benign economic backdrop. While we think current credit spreads look reasonable based on credit fundamentals and compared with historical averages, US interest rates will likely be the major source of risk. We think a duration-neutral strategy against benchmarks may be more effective to avoid excessive volatility.
We believe investors should also stay away from crossover issuers to avoid the risk of a potential rating downgrade that could pull the bond into HY territory. We think with a more uncertain growth outlook and interest rate risk, an IG portfolio with higher overall credit quality should generate better risk-adjusted returns.
The surge in ESG-linked bonds in Asia in 2021 has underscored the market’s demand for companies with strong performance on environmental, social, and governance measures. Over the last 12 months, premiums in pricing between strong- versus poor- performing companies on ESG have become more and more discernible.
Source: JPMorgan as of 30 September 2021. For illustrative purposes only. We are not soliciting or recommending any action based on this material.
ESG-related sectors like renewables are gathering more and more technical support from US and European investors, which is partly driving higher pricing given tighter comps in developed markets. In previous years, Asia represented around 50% of renewable deals; today, Asia, Europe, and the US have roughly the same share.
For companies performing poorly on ESG, the window for raising capital in the offshore US dollar market appears to be narrowing as the investor base shrinks, potentially pushing issuers toward more serious ESG commitments in return for capital. Refinancing risks will be higher going forward for credits with large bullet maturities (such as Indonesian coal mining companies and Australian coal terminals) and will need to be monitored closely. Issuers with amortizing bond structures (such as Indonesian coal independent power producers) will be better placed from a refinancing risk perspective.
Sustainability-linked bonds (SLBs) have been a new development to the Asian market in 2021 and are likely to become more commonplace going forward. These are often issuers with below-average ESG characteristics that have set out sustainability targets, which, if not met, could result in a coupon step-up at a specific year (usually close to the final year). While they sound good on paper, most of the issuers of these bonds thus far have either unambitious targets or negligible, non-punitive coupon step provisions, in our view, which offer limited additional incentive for them to work toward achieving those targets. We believe greater scrutiny from the investor community will be needed to make the targets/compensation more meaningful.
The stable outlook for the Asia bond market could face potential headwinds from rising inflationary pressure in the West, the slowdown in China, and any return to widespread Covid-19 lockdowns. While we still view current inflationary risk as transitory, the longer the disruption in global production chains persists, the higher the risk that inflation becomes cyclical, if not structural. While we currently do not expect this outcome, we think the risk is growing. With this is mind, we are mindful of potential interest rate shocks should inflationary forces become more entrenched.
Meanwhile. the surge in oil prices coupled with a slowdown in China may be a double whammy for some Asian countries, which may end up importing inflation into their domestic economies while facing a reduction in exports to China.
Covid-19, while becoming less of a market disrupter as vaccinations progress across the region, may still have the potential to roil markets should more infectious and vaccine-resistant variants emerge and force new lockdowns.
Overall, the uneven recovery that we have seen in 2021 is likely to continue as inflationary forces play out differently across the global economy, complicating the timelines toward rate normalization as well as the momentum of corporate recovery. Flexibility and credit selection will remain the watchwords for 2022.
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