SUMMARY
- Recent developments in the region’s two largest economies, Japan and China, illustrate the importance of carefully assessing a company’s management and incentive structure prior to investing in its bonds.
- In Japan, management is focused on return on equity (ROE) and increasing shareholder return, and in China, state ownership tends to dominate traditional sectors, while private entrepreneurs are driving new economy sectors, both creating risks and opportunities.
The annual movement of wildlife across the Serengeti-Mara ecosystem in Africa is one of the greatest spectacles in the natural world. The horizon fills with wildebeest, zebra, eland and gazelle migrating for fresh grass, tracked by Africa’s great predators.
After watching this natural spectacle last year, I found striking similarities with the secular evolution of the Asian credit market. Like the dynamic on the Serengeti, many overarching themes in Asian credit remain consistent from year to year, but the scene unfolds in a unique way every year. In Asia credit, the variations arise mostly from management actions and corporate governance (or lack of them), which create spread volatility ‒ and potential investment opportunities.
As an investor, we ask key questions when we consider investing in a company’s bonds: Who is management? Are they acting as fiduciary agents or exhibiting predatory behavior? What is their incentive structure? Are they also owners?
Looking at recent developments in corporate management in the region’s two largest economies, Japan and China, illustrates how important the answers to these questions are.
Japan Under Abenomics
In Japan, corporate management is focused on return on equity (ROE) and increasing shareholder return, stemming largely from the reform initiatives introduced under Prime Minister Shinzo Abe, known as “Abenomics.”
Before Abenomics, holders of Japanese corporate bonds were rewarded by management’s incentive to reduce leverage through cost reductions and non-core asset sales. Today, amid a fragile economic recovery anchored by a relatively weak yen, corporations are focused on increasing capital expenditures and return on equity, as well as on hiring and wages. Over the long run, it will be important for bond investors to distinguish between companies that are re-leveraging to boost ROE and those with organic top-line growth.
In Japan’s banking sector, the Bank of Japan (BOJ) recently introduced negative interest rates, with a current charge to banks of 10 basis points for funds on reserve. Because it is difficult for banks to charge negative rates to customers for deposits, this will likely lead to net interest margin compression and deterioration in profitability. Although we view this as manageable, especially for the largest banks, we expect bank management teams to try to absorb the hit by charging part of the cost to depositors, changing asset allocations (possibly taking more duration risk and increasing foreign investments) and focusing on fee businesses. Mortgages and other real estate loans may increase, but given the banks’ conservative underwriting policies and persistently weak domestic loan demand, we do not expect significant loan growth.
We favor the Japanese mega banks’ total loss-absorbing capacity instruments, which benefit from government support, strong stand-alone credits and attractive yields.
China: Knowing The Risks
China offers unique opportunities and risks when it comes to management. PIMCO estimates that approximately 65% of all fixed assets in China, including the excess capacity sectors of steel, coal mining, cement, shipping, aluminum and glass, are state-owned enterprises (SOE). However, economic growth today is being driven by the new economy, including the consumer, Internet, technology, healthcare, education and services sectors, where private entrepreneurs have produced handsome returns for equity holders, and to some extent, bondholders.
Perhaps no sector illustrates the unique risks in China better than commodities and specifically, metals and mining.
As China’s economy rebalances away from exports and toward domestic consumption, growth has slowed and commodities markets have been hit hard, especially metals. Figure 2 shows the underperformance of the U.S. high yield metals and mining sector as demand from China has slowed over the past two years. A steep fall in metals prices, currency devaluation, excess supplies and collapsing cost curves have led to imploding balance sheets, massive excess capacity and the need for companies to divest by selling equity or assets over the past few years. Since 2014, of all commodities, the metals and mining sector has seen the largest bondholder pain in the form of defaults, and most of these can be attributed to management behavior. While the state-owned mining companies in China continued to over-produce ‒ despite economic losses ‒ due to the availability of financing and state support, privately owned miners and commodity traders lacking that support across China, Indonesia, India and Australia were fighting for solvency.
The desire by company managements to save pennies by refinancing nearly pushed several Asian mining companies into a liquidity crisis in 2015, when accessing capital markets came at a higher price than expected. In addition, many poorly informed management teams bet incorrectly on the direction of commodity prices and were then forced to engage in distressed debt exchanges or default outright, causing severe losses for bondholders. And poor disclosure about commodity trading models resulted in severe stress for several trading companies. Only a select handful of mining companies took positive action, such as refinancing at lower all-in cost, cutting dividends or retiring debt early using excess cash on hand.
Our current underweight in the global metals and mining sector stems from an early non-consensus call on Chinese metals demand in 2012. Since then, we have generally exited or avoided most higher-cost mining credits. The outlook for 2016 is far from optimistic. We continue to monitor underlying physical demand indicators in China, and strong managements that take actions with positive implications for credit quality will continue to be the anchor for future investments.
Understanding The State's Role
For investors, a dilemma occurs when the state has a dual role as manager and owner of assets. How do we measure management’s incentive structure? It could be geared toward the government’s goals, such as employment, wages and taxes for the provincial governments, rather than returns.
Key examples include the lack of progress in closing down excess capacity in old-economy sectors, such as mining, although some improvement is being made under President Xi’s blueprint for restructuring SOEs. At the same time, however, the anti-corruption agenda has stalled or frozen management action on new projects and capital deployment. As a bondholder, when we decide to invest in SOE credits we need to be absolutely sure that we select ones that are vital and strategic to the state and will benefit from any supply adjustment. (See Figure 3.) We currently favor investments in strong investment grade oil and gas, utilities, consumer and Internet companies.
What about the new economy sectors? Taking the Internet sector as an example, there are currently three companies controlled by their founders, but they have different approaches to expansion.
While all are M&A focused, one believes in complete integration and full operational control to realize maximum synergies while the others focus on alliances with companies in key verticals through minority ownership and partnerships. Both strategies can work, but they can result in different outcomes for bondholders in the long run, so we appreciate management teams that can communicate clear growth paths for their businesses. The Chinese Internet companies generally enjoy excess cash balances versus total debt, but their credit risk premiums can diverge when strategic investments in new areas of growth do not generate returns that justify the cost of capital.
In the banking sector, there is a lot of anticipation for mixed ownership reform in China’s largest state-owned banks. The key issues are: (a) to what extent is the Chinese government willing to lower its stake in banks? (b) Will the senior management of banks continue to be government-appointed? © Upon mixed ownership reform, will banks continue to carry the social duty of lending for un-economic returns? (d) Will the management remuneration system of banks be more linked to business performance or share price? These are questions to which answers may not be available in the short term. A good sign is that bank regulators have eased liquidity and capital requirements. Thus the regulatory environment is in favor of bank shareholders, and to a smaller extent, bondholders.
Finally, China’s property sector has been a bastion of idiosyncratic risk for bondholders, including defaults, poor corporate governance that hides liabilities from investors and even the arrests of senior management or owners. Given the secular bull market enjoyed by property developers until 2014, most had no intention of deleveraging their balance sheets as long as they could still extract profit (albeit at shrinking margins) from existing or new projects. Without experiencing much cyclicality in the past and being strong believers of “too big to fail,” most players in this sector focused on scaling up and growth, sometimes using offshore U.S. dollar debt to finance growth. Investors should therefore be selective in the property market and stick to large, diversified developers with an established management track record operating in Tier-1 and stronger Tier-2 cities in China. Given the stellar bond investment returns seen in 2015, we expect limited outperformance potential in 2016 despite a supportive macro policy stance for new home purchases.
Positive Outlook for 2016
A very experienced guide can help visitors understand Africa’s annual wildlife migration. Similarly, an expert in the complex Asia credit markets can help investors uncover the best opportunities and avoid the hidden perils that can lead to extreme credit spread volatility and even default. At PIMCO, our on-the-ground research team in Asia is focused on identifying the risks and the companies that can benefit from the structural adjustments underway in these economies.
Overall, we are bullish on higher quality investment grade credit for the year ahead. Although we expect that the markets will remain volatile as the region adjusts to China’s slowdown and currency devaluation, we expect to add Asian credit during periods of market dislocation or heightened volatility and invest in new bond offerings that we believe present attractive investment opportunities in new economy sectors across the region.
The author would like to thank PIMCO’s Asia Credit Research team for its contributions to this article.
Disclosures
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy. Investors should consult their investment professional prior to making an investment decision.
