December 11, 2015 10:00 pm JST
The past year has hardly been easy for Asian high-yield debt investors coping with a generational slowdown in the Chinese economy and the commodities market. Unfortunately, neither has turned a corner and now markets face a further threat to liquidity as the U.S. Federal Reserve prepares for its first rate hike in a decade.
Rising interest rates are typically viewed as negative for high-yield issuers as fewer investors will need to invest in the riskier end of the spectrum to get yield. But perhaps the bigger challenge for emerging market bonds is the reaction of global fund flows to stronger growth and higher interest rates in the U.S.
With the Bank of International Settlements warning again on Dec. 6 that rate rises will hit emerging markets, will we see another incarnation of the “taper tantrums” of 2013, then brought on by the Fed’s comments about reining in quantitative easing?
Some comfort can be taken from the fact that such risks are well recognized and have long been factored in by the markets. The Fed has indicated it is aware of the global repercussion of a rate hike and is likely to move in small increments.
Take China, for instance, where a U.S. rate hike will have an impact. China is in the middle of its own rate-cutting cycle, and it also maintains a loose currency peg to the dollar. This combination sets up a risk that after a multi-year U.S. dollar bond issuance spree by Chinese corporates, a toxic debt and currency mismatch could emerge, similar to the Asian financial crisis of the late 1990s.
It is encouraging that Chinese authorities have taken steps to prevent this.
The surprise Aug. 11 yuan devaluation can be viewed as a pre-emptive move to prepare the market for more exchange rate volatility going forward. This came soon after the re-opening of the domestic yuan bond market to property developers.
Chinese companies have since shifted their borrowing from offshore to onshore at a record pace. Domestic bond issuance has reached 312.8 billion yuan year-to-date, with real estate accounting for the lion’s share at some 150.4 billion yuan, according to data company Dealogic.
The combined effect is to reduce the potential for credit pain around debt-currency mismatches. Some companies have used cheaper onshore funding to retire foreign currency-denominated debt. Domestic Chinese property bonds have been issued with an average coupon of 5.5%, approximately 3.25 percentage points lower than that of offshore issues. The aggressive switch to onshore funding helped the offshore Chinese property sector become the top performing area within Asian high-yield debt this year.
As ever when assessing the outlook for high yield in China, understanding state policies and priorities remain critical. A crucial distinction should be made between the property market and commodity-related industries.
The former remains a top priority for Beijing, as more than anything, the property sector as a whole is “too big to fail,” given its systemic importance to banks and the wider economy. For China’s emerging middle class, property is a must-have investment asset.
But while government policy is expected to remain accommodative to support the property sector, it will be very different for commodities and China’s smokestack industries.
After three years of slumping commodity prices, losses have been piling up, leaving a number of “zombie” state-owned enterprises in which substantial capital has been injected just to maintain employment. Such policy support will be unsustainable in the absence of a price recovery in the sector. As a result, we see an increase in defaults in 2016.
Companies facing debt redemption will struggle to refinance in distressed sectors including mining, mining services and commodities such as oil and gas.
China’s slowdown is also playing a critical factor in regional high-yield markets, which depend on the country’s appetite for commodities. Chinese policies on steel and coal production will be watched carefully. This is particularly the case for Indonesia, where many commodity-related high-yield bonds have been hammered by the disastrous combination of falling prices in the sector and fears about yuan devaluation. This distress has been compounded by falls in the rupiah, which has been trading near levels last seen during the Asian financial crisis. This pain is likely to continue in 2016.
Offshore investors in Asian credit will be reminded why they are getting extra yield in 2016. They must navigate not just weak commodity prices and a rise in U.S. interest rates but also political and governance risks while holding deeply subordinated paper. If there is a default, offshore bondholders have little leverage as domestic creditors and stakeholders invariably come first. In such circumstances, often an overseas investor’s biggest consolation is the knowledge that management has a powerful incentive to avoid default to protect offshore stock listings and the future access to funding that comes with them.
Ultimately in high-yield investing, volatility and uncertainty can bring numerous opportunities, not just challenges, for the astute investor.