This is a sponsored article from Legg Mason Global Asset Management.
We should see a gradual recovery anchored by Greater China
Last year’s exuberance in Asian bond markets has dissipated fast as worries about the COVID-19 virus have escalated. Desmond Soon, head of investment management for Asia ex-Japan at Western Asset, says his fixed income team has simplified portfolios to curb risk and focused on the fundamentals. High-quality local and hard currency bonds will rebound as economic activity returns.
Asian bond markets finished 2019 in spectacular fashion; with Asia bond markets posting double-digit returns, leaving valuations rich. The stellar year topped a long run that started after the global crash of 2008. A correction was inevitable, thought Soon.
“In early January, investors were bullish as we headed into a US Presidential re-election year and phase one of the US China trade deal had just been concluded,” he says.
Subsequent events have already undone early gains in Asia bond markets this year, as they have done around the world. Dollar-denominated Asian credit was particularly badly hit. As Soon points out, however, Asian corporate and sovereign credit has outperformed other bond indices on a relative basis, reversing their typical premiums over their developed market peers.
Source: Bloomberg, as of 31 March 2020. Asia USD credit represented by JP Morgan Asia Credit Index Composite; Asia Local Currency represented by Markit Iboxx Asian Local Bond Index; EM USD Credit represented by J.P. Morgan Corporate EMBI (Emerging Market Bond Index)Composite Index Level; EM Local Currency represented by J.P. Morgan GBI-EM (Government Bond Index-Emerging Markets) Broad Diversified USD Unhedged Index. EM: Emerging Markets.
“Asian investment grade (IG) credit spreads used to be 60 basis points above US IG bonds. That spread has been eliminated, US IG spreads are now on par with Asian dollar-denominated IG credits,” he says.
There are a number of reasons why Asian bonds have fared relatively well. As the number of local issuers has increased rapidly in recent years, so local investors have bought up large numbers of bonds from companies they are familiar with. Chinese issues now make up over half of the market capitalisation of the J.P. Morgan Asia Credit Index (JACI).
“There are a lot of Chinese investors buying Chinese bonds. They are very comfortable buyers and a captive audience for household name issuers,” says Soon.
‘Simplifying your Asia bond portfolio is key, says Desmond Soon’
Asian buyers are less spooked by the world’s other major financial upset – the recent unexpected fall in oil prices. With the exception of Malaysia, lower oil costs are good news for local economies and lower energy input costs should boost the resilience of many Asian issuers. Local currency bonds in the most resilient markets have performed relatively well in the risk-off environment, notes Soon.
“In local currency terms, Chinese yuan bonds have risen as investors gravitate to bonds. For them, local currency bonds are more a safe haven ‘Treasury-like’ investment than a credit product,” he says.
Similar patterns of safe haven buying and holding can be seen in Singapore, South Korea and Hong Kong government bonds. Even so, some bond holders have been selling, but more out of necessity to raise cash than fear of a slowing global economy. Private banks, traditional buyers for their clientele of leveraged fixed maturity products or structured portfolios have seen liquidation due to margin calls.
Simplifying the portfolio
Soon and his fixed income colleagues have prepared the Legg Mason Western Asian Opportunities strategy* for further bouts of volatility.
“As in the Asian financial crisis and 2008, correlations tend to break down. Things that are supposed to diversify break down. It is very important to not over-complicate, we have kept the portfolio as simple as possible,” says Soon.
That means winding down hedging positions to reduce leverage and basis risks. The team has scaled back their derivatives exposures that are used to control bond duration or the effects of currency movements in more normal times. Cash levels have also been raised, even though redemption demand has been relatively contained.
“The decks have all been cleared,” says Soon.
He sees early signs of a rebound in economic activity in China and the first wave Covid-19 infected countries, due to significant drop off in virus infections and rising case recoveries. This is underpinned by strong government fiscal and monetary stimulus. Over 60% of Chinese employees have gone back to work. Other industrial indicators like coal consumption are rising.
“We should see a gradual recovery led by Greater China,” he adds. “There is massive global stimulus in the system and, once the virus kinetics abate, financial markets can rebound. But the impact will be uneven across assets and sectors. For example, the travel industry will bear the virus scars for a long time.”
A return to normality will calm Asian bond markets, but the Western Asian Opportunities team will remain cautious. Soon says vigilance is key in determining how bond issuers recover and how quickly. A U-shaped economic rebound would be ideal, he thinks. When recover comes, he and his team will look for dislocated assets and avoid those that have been impaired.
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* Legg Mason Western Asian Opportunities strategy refers to Legg Mason Western Asset Asian Opportunities Fund.
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This is a sponsored article from Legg Mason Global Asset Management.