This is a sponsored article from PineBridge Investments.

For investors looking to escape the negative-yield environment, Asian bond markets offer a potential refuge with higher yields and stable returns. But to make the most of this opportunity, investors must navigate idiosyncratic risks and the impact of policy and politics, such as the recent Chinese yuan movement and the uncertain trajectory of the US-China trade negotiations.

Asian fixed income saw strong inflows in the first half of 2019. While the region’s bonds are still underrepresented in global benchmarks, investors are increasingly recognising their diversification benefits and, contrary to the general misconception, the Asian bond market is not a high yield market with high beta and volatility.

Over the past five years, Asian bonds’ Sharpe ratio (a measure of their volatility-adjusted return ratio) has held up very well at 1.59 compared with those of other major asset classes globally (US investment grade credit at 0.99, emerging markets USD at 0.94, and US equities at 0.88).¹ One reason for this is a strong domestic investor base that understands Asia’s bond market.

Asian bond issuers also tend to have very low gearing ratios (corporate net leverage) and high interest coverage ratios compared with their emerging market — and even some developed market — peers. This is another reason why the Asian market has managed to deliver such a high Sharpe ratio over different business cycles, as well as through some major macro events in the past five years.

Since the 1997 Asian financial crisis, there have been no defaults in the Asian investment grade bond universe. In addition to high credit quality, high systematic government support for some issuers, especially state-owned enterprises, contributes to the market’s stability. Where market volatility does exist, therefore, we think the Asian bond market actually becomes more attractive to long-term institutional investors.

Investing selectively to navigate trade twists and policy pivots
Two themes have figured prominently in the Asian bond market this year: shifts in monetary policy and the US-China trade dispute.

The US Federal Reserve’s pivot towards easing and the accommodative stance of some of the region’s central banks have provided a positive backdrop for Asian bonds. With developed market bonds offering negative to negligible yields, higher-yielding Asian bonds are becoming harder to ignore.

On the other hand, given uncertainties around the trade dispute between the US and China, we expect Asian bond and currency markets to remain choppy in the near term. As an anchor currency in the global market, the Chinese yuan’s recent move past against the US dollar and the US designation of China as a currency manipulator will likely intensify the volatility in the currency market in the region and trigger more risk aversion. However, the majority of Asian bond issuers are domestically focused, or have revenue largely sourced in US dollars. As such, we do not believe higher volatility in the yuan will cause a large-scale credit deterioration in Asia bond markets.

The trajectory of the yuan will hinge to a great extent on the development of trade negotiations. Additional and further negative developments in the trade talks with the US will mean China is less likely to hold a conciliatory stance on the currency, given greater pressure to mitigate negative tariff-related impacts.

Over the long term, we expect the Asian bond market to remain resilient and attractive. On an index level, less than 3% of Asian bonds are directly affected by the tariffs, and the tariff impact is not linear. Some companies may absorb the cost of tariffs through margin compression. While an unfavourable outcome to the dispute could hurt economies like Korea, Japan, and Taiwan, it could benefit others through production shifts from China to Southeast Asia, for example.

Active management offers the flexibility to navigate across the risk spectrum and adopt a more selective approach.

Identifying opportunity in a complex investment universe
In the diverse Asian bond market, the key is to be more tactical in allocating across sectors, countries, and names. A holistic view of economic and political developments, along with rigorous credit analysis, will become even more critical.

The Chinese property sector, for example, offers select opportunities within a fragmented market. Defaults have risen recently on the back of the nationwide deleveraging effort, and we expect weaker and marginal developers to continue facing challenges. However, in our view this is unlikely to become systemic, and we expect the sector’s overall credit quality to improve over time.

Meanwhile, a new rule states that Chinese property companies can only issue USD bonds for refinancing offshore long-term debt maturing within one year. This has both positive and potentially negative implications. The rule essentially sets a cap on the total amount of offshore long-term debt, which should provide supportive technical drivers for Chinese property bonds. But it could also create funding and liquidity pressures for companies with weaker credit profiles or limited access to multiple funding sources.

Another example is Indian regulators’ recent larger-than-expected capital injection plan for the banking sector. We believe the initiative should help public sector banks and the broader banking system in dealing with asset quality and liquidity issues. This should present potential investment opportunities in this sector, but only if the plan is effectively implemented.

These developments underscore how value can be highly dispersed across Asian bonds, making credit selection particularly important. The investor who can selectively identify stronger players can seize those opportunities.

This is a sponsored article from PineBridge Investments.