Asian high-yield debt market will be tested
Investors increasingly edgy amid uncertain liquidity
26 June 2017
Viewpoints > Michel Lowy
Asian high-yield bonds have performed strongly over the past year, shaking off concern over defaults and expectations of higher U.S. interest rates.
Many had thought that higher rates and a strengthening global economy would trigger an exodus of funds from Asia and bring down prices. Instead, the iShares Barclays High Yield Bond Index has risen 8% since June 2016. Signs are pointing however to a bumpier ride ahead for Asian high-yield investors.
A partial recovery in commodity and oil prices has created a virtuous economic backdrop for high-yield, or junk, debt. It has given some breathing room to many distressed metals, mining and oil-related issuers across the region that had been flirting with default following the end of the commodity super cycle. This modest commodity rebound has yet to amplify fears of inflation, giving the U.S. Federal Reserve room to soft-pedal interest rate increases.
By keeping the “lower-for-longer” interest rate regime in place, this has also helped fuel an upswing in issuance as investors have remained fixated on yield. In the first quarter of the year, 26 Asian high-yield bond issues raised $10 billion, more than double the proceeds of the previous quarter, according to ratings agency Moody’s Investors Service.
Notably, this funding window has stayed relatively open to just about everyone, including companies in distress. This is important as it has neutralized the biggest risk for high-yield: default.
In effect, this “virtuous alignment” has propped up fundamentals and liquidity at the same time. The risks, however, are twofold: Investors’ perception of risk can be dulled which may leave them overexposed, and the supportive economic backdrop may turn adverse.
Already there are signs of pockets of distress emerging. Despite overall market strength, overreactions to negative news indicates investor nervousness remains. Bad earnings news and questions raised about issuers’ repayment ability have led to large swings in bond prices and widened spreads.
It is fairly hard to predict any directional change in liquidity, but some uncertainties are emerging. Despite continued U.S. rate increases, the market is still not expecting a more rapid upward movement that could trigger a sea change in liquidity.
China is another key element of the picture given that it dominates Asian issuance outside Japan and that mainland buyers are an increasing presence in the offshore market. Chinese authorities made large liquidity injections last year, resulting in looser policy than many expected. This played an important role in the commodity recovery and ongoing strength in the country’s property market.
This year, the task for policymakers remains challenging, as they must juggle managing deleveraging and capital outflows while also keeping growth positive. Indeed, Moody’s has been the latest to warn on the financial challenges facing China, issuing its first downgrade of the country’s sovereign rating in 27 years.
To date, these fears have been mainly background noise, with confidence in policymakers and continued liquidity keeping high-yield buoyant. Yet investors need to be alert to any fine-tuning in policy, both due to the possible economic impact and the potential to affect offshore bond liquidity.
For instance, a relatively recent phenomenon has seen Chinese companies return to the offshore issuance market due to domestic tightening measures. This is a reversal of what was seen over the previous 12 months when the same companies retreated to onshore markets to raise funds, helping to create a high-yield scarcity premium in offshore markets.
The offshore market has been able to absorb the fresh bond supply. One reason for this has been the growing participation of Chinese money managers, many based in Hong Kong, in the offshore market. Some reports suggest Chinese buyers have been buying as much as half of Chinese dollar bond issuance this year.
While this has brought a positive addition of liquidity to the market, there is some uncertainty about its longevity. In the past, Chinese authorities have shown a tendency to intervene in both domestic stock and bond markets to curtail new issuance or prevent capital outflows and this may well happen again. Such action needs to be factored in to the overall issuance supply-demand balance.
In the “virtuous alignment” for high-yield, China plays an important role. Its economy and industrial demand remains key to the wider health of the commodity complex across Asia. This year we have witnessed a continued weakening in commodity and oil prices. As authorities seek to deleverage, more downside is possible.
High-yield investors will be more demanding and selective going forward as risks become more apparent. It will be increasingly important to look carefully at each issuer on a case-by-case basis and their ability to repay or refinance. Relying on liquidity as a backstop for the market will no longer be enough.
Michel Lowy is chief executive of SC Lowy, an investment bank based in Hong Kong.