When Risk-Free is Risky, Asia May Provide a Bright Spot for Fixed Income Investors

We've seen a lot of volatility in U.S. interest rates around the recent U.S. elections. Can you give us a roadmap of what to expect?

U.S. 10 year treasuries bottomed in August at 50 basis points (0.50%) and we're approaching 1%. Though the global recovery has been two steps forward, one step back, the worst of the economic fallout from the Great Pandemic is likely behind us. This means that U.S. rates are more likely to rise than to fall over the next year. Yields are skewed to rise even more as we recover from the pandemic.

What are the implications?

For asset allocation, the implications are profound. Historically, U.S. treasuries have provided yield, total return and diversification benefit. However, three major developments have undermined U.S. treasuries as a core asset:

  1. The Fed's commitment to positive rates limits the price appreciation and the diversification benefit of U.S. Treasuries
  2. Both emerging markets (EM) and developed markets (DM) government bond yields are close to historical lows. With inflation unlikely to fall further, the scope for duration gains is limited
  3. Negative correlation between U.S. Treasuries and equities has already begun to break down since the global financial crisis, undermining its diversification benefit. When rates are so close to zero, there's only so much upside to treasuries even if we experience another bear market.

Bottom-line: Risk-free is risky. Investors will have to find and allocate to other assets for yield. This is not just tactical, but a strategic change in allocation for the next decade in my view.

Where would you allocate to?

The logical place would be to look to the economic engine of the next decade, which is going to be Asia, driven by China. Moreover, we expect the fates of EM economies will be increasingly linked to that of China, not the U.S. Exports should continue to be a key drivers of growth for emerging markets and China's dominance as the world's largest importer should grow.

The growth story of China is well-known. Less understood is China's global importance as a global creditor, can you elaborate on that?

Yes. China has grown to be the world's largest official lender to emerging market countries, with empirical research showing that China is now larger than any multilateral lender, including the Paris Club, the World Bank or the IMF. China's Belt and Road Initiative is just a formalization of its “Marshall Plan” and I believe will continue to be a major source of foreign direct investments in most of EM. Last but not least, with index provider FTSE Russell's announcement to include China into its World Government Bond Index (WGBI), China's bond market is becoming a ubiquitous part of global bond allocations. It is now included in the world's biggest bond indices, including the Bloomberg Barclays Global Aggregate Bond Index, aka “the Agg.”

The point here is that Asia would be fertile hunting ground for yield as the region grows and its capital markets deepen.

What about other parts of EM?

Since the birth of EM as an asset class in the 1990's, Asia has outperformed other regions. This is the case whether you put Asia high yield head to head with Latin America (LatAm) high yield, or Asia investment grade bonds with LatAm investment grade bonds. Most importantly, COVID has tilted the playing field in favor of Asia. China's structural growth has not been materially impacted by the pandemic. But that's unfortunately not the case for much of the emerging world. For example, the IMF expects LatAm to return to pre-COVID GDP levels in 2024—that means a lost half decade for LatAm.

It sounds like you see stars aligning for Asia bonds. Can you speak to each dimension of return: rates, currency and credit?

In terms of rates, I believe investors will look increasingly to Asia fixed income as an attractive alternative to U.S. Treasuries, as it offers a spread above U.S. Treasuries. In terms of currency, long-run growth differentials favor Asia over other EM economies. Asian currencies also have room to appreciate relative to the U.S. dollar, especially if the U.S. growth undershoots. And finally, in terms of credit, Asia looks cheap relative to its own history and cheap relative to U.S. high yield.

Which sectors do you favor?

China property continues to offer good value. This is especially the case since the Chinese government implemented new rules, known as the three red lines, which basically prevents a property company from being too aggressive in taking on leverage. This is great news for bond investors as these guard rails around debt translates into guard rails around leverage that should result in lower financial risk, lower spread, and higher price for property bonds.

Have we missed the boat? Is there still good relative value?

Yes, there is still good relative value. For example, Asia high yield spreads are still wide relative to past levels and relative to U.S. high yield spreads. Today, U.S. high yield spreads, as measured by Bloomberg Barclays US Corporate HY Index, yields only 4.7% while Asia HY yields spreads as measured by the high yield potion of the JP Morgan Asia Credit Index, yields 7.8%. That's an incremental yield of 300 basis points higher for Asia high yield over U.S. high yield. This is mainly due to the Fed's asset purchase program, which includes U.S. high yield. Without one central bank providing a bid in the Asia market, this just means that prices have been slower to recover, leaving a window of opportunity for investors.

Fixed income investments are subject to additional risks, including, but not limited to, interest rate, credit and inflation risks. Investing in emerging markets involves different and greater risks, as these countries are substantially smaller, less liquid and more volatile than securities markets in more developed markets. Securities denominated in a foreign currency are subject to the risk that the value of the foreign currency will increase or decrease against the value of the U.S. dollar.

The Barclays Global Aggregate Index (GAI) provides a broad-based measure of the global investment grade fixed-rate debt markets. The GAI contains three major components: The U.S. Aggregate Index, the Pan-European Aggregate Index, and the Asian-Pacific Aggregate Index. In addition to securities from these three benchmarks (94% of the overall Global Aggregate market value as of December 31, 2010), the Global Aggregate Index includes Global Treasury, Eurodollar, Euro-Yen, Canadian and Investment Grade 144A index-eligible securities not already in the three regional aggregate indices. The FTSE Russell World Government Bond Index (WGBI) is a broad index providing exposure to the global sovereign fixed income market. The Index measures the performance of fixed rate, local currency, investment-grade sovereign bonds. It comprises sovereign debt from over 20 countries, denominated in a variety of currencies. The J.P. Morgan Asia Credit Index (JACI) tracks the total return performance of the Asia fixed-rate dollar bond market. JACI is a market cap-weighted index comprising sovereign, quasi-sovereign and corporate bonds and is partitioned by country, sector and credit rating. JACI includes bonds from the following countries: China, Hong Kong, India, Indonesia, Malaysia, Philippines, Singapore, South Korea and Thailand.

The views and information discussed in this report are as of the date of publication, are subject to change and may not reflect current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. Investment involves risk. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. Past performance is no guarantee of future results. The information contained herein has been derived from sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Matthews Asia and its affiliates do not accept any liability for losses either direct or consequential caused by the use of this information.

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