For Global fixed income investors, what is your biggest call for 2021?
Emerging Markets (EM) Corporates. We think EM corporates will outperform EM sovereign credits. The term “EM fixed income” is typically associated with EM sovereign bonds. Sovereign bonds are the most typical holdings for EM bond investors. The addition of about 30 new frontier markets to the JP Morgan Emerging Market Bond Index Global Diversified over the last decade has increased investors’ exposure to countries that will struggle to recover from COVID. Since the Global Financial Crisis, EM hard currency corporates have outpaced EM hard currency sovereigns in issuance. Nevertheless, EM investors are still largely invested in EM sovereigns, not EM corporates. The EM hard currency corporate market is dominated by Asian issuers, of which more than half are China issuers. Given the V-shaped recovery of China and the positive spillovers onto much of the region, we expect Asia to outperform other EM regions. We also expect Asian corporates to outperform corporates from all other EM regions. When you take into account a yield of about 7.4% in Asia high yield, with help of some credit spread tightening, we are looking at returns of high single digits to 10% next year.
Speaking of Asia high yield, what are your thoughts on some of the recent bond defaults with Chinese issuers?
Defaults are a necessary evil. They are signs of a maturing capital market like that of China’s where participants have to be sophisticated analysts of credit risks to generate superior returns. Investors can no longer just rubber stamp an investment because it has a guarantee or a keepwell agreement from a government entity, even for companies of strategic importance such as semiconductors as in the case of Tsinghua Unigroup. The recent defaults are by companies that share commonalities of weak corporate governance, poor financial performance, and a track record of making questionable investments. By allowing poorly managed companies or ones with unsustainable capital structures to default, the Chinese government is preventing moral hazard and enforcing good governance and fiscal discipline. This has been a consistent goal of Chinese policymakers for over a decade. The importance of discerning credit risk underscores the need to invest with active managers like ourselves, where my job is to avoid defaults and to seek the bonds offering the best risk-adjusted returns.
What are the implications for future defaults?
While the overall default rate in China is rising, it is still low relative to other markets. Because the economy is healthy as it has staged a remarkable recovery from COVID, we see default rates rising but likely to remain in the in low single digits, compared to U.S. high yield, which is around 6% on a 12-months trailing basis.