Key Points

  • The rapid development of the Asia Credit markets provides new opportunities to improve the risk and return profile for investors. Asia Credit creates additional fixed income diversification benefits over the US Aggregate Bond (US Agg), or a fixed income allocation already diversified across the US Agg, US High Yield, Global Sovereign and Emerging Market Debt
  • While Asia Corporate Debt requires unique credit research skills, we believe that due to major geopolitical and macro risks in emerging markets, investors should take a more selective approach by incorporating Asia Investment Grade issuers as a separate allocation within this universe
  • In particular, adding Asia Investment Grade Credit (IG) lowers downside volatility for both US Investment Grade or Emerging Market Debt portfolios, thus providing institutions with an important risk mitigation tool. We believe that there are key fundamental and technical trends that will support this lower volatility and source of quality yield for a long time into the future
  • While Asia Investment Grade (IG) has delivered moderate returns (+4.0%) YTD compared to higher beta segments of EMD, it still offers a robust yield vs. US IG, and its downside volatility is far lower than other EM regions, or even US peers
  • We believe there are key fundamental and technical trends that support this low volatility, and Asia Credit IG in particular offers US investors a defensive tactical allocation within EMD, while also providing a long-term source of quality yield

Making the Most of Emerging Markets...

Throughout 2016 and 2017, Emerging Markets Debt (EMD) has performed very well for investors. However, this has attracted strong asset inflows, which has compressed yields such that EMD valuations are now at historic highs. At the same time, there remain a number of potential key risk factors for EMD:

  1. The US Fed is clearly on a path of raising rates, and while moderate rate rises so far have not impacted EMD, such will likely provide an increasingly competitive source of yield for investors.
  2. Similarly, the political risk of the US adopting more protectionist “America First” trade and tax policies also needs to be considered. At present, this risk appears to be muted by the difficulties of the Trump Administration in implementing its agenda, but it remains a potential catalyst for downward revision in EMD.
  3. Finally, there is potential for oil prices to fall. Much of hard currency EMD – particularly in the high beta segments – is linked to oil-related issuers, and a drop in oil prices would negatively impact them.

Given these risk factors, it makes sense for US investors in EMD to assess how they are positioned, and consider how they could reallocate to lower beta segments to limit downside volatility without sacrificing too much yield. Indeed, with the growth of the EMD universe, there is now sufficient size and diversity for investors to take selective positions. CEMBI and EMBI make up a combined market size of USD 1.3 trillion with 506 different issuers. Within EMD, Asia Credit IG is now a significant segment in its own right. For instance, the JP Morgan Asia Credit Index Asia (JACI) IG now measures USD 600 billion.

Asia as a Component of EMD

Market Size (BN) Number of Issuers
CEMBI + EMBI 1,318.09 506
Asia 401 204
Latin 491 143
Europe 267 84
Middle East 85 41
Africa 75 34

Source: JP Morgan April 2017; Note that JACI has higher market size than CEMBI + EMBI Asia given the lower minimum size requirement for JACI.

The chart below confirms the superior Sharpe Ratios for USD debt in Asia:

Asia Credit IG Risk Return vs Other Credit Segments

Source: Nikko AM, Bloomberg, Markit, JP Morgan, 31 May 2017

Emerging Market Debt - Regions by Yield vs Duration (CEMBI)

Source: JP Morgan, 28 April 2017

Why is Asia Credit Volatility so Low?

As the charts below show, Asia Credit has not only been less volatile that other high beta Emerging Market regions, but even lower than US IG, and the same is also true comparing Asia Credit High Yield to US High Yield.

JACI is less volatile than CEMBI, EMBIG and CGI-EM

Source: JP Morgan, Asia Credit Outlook and Strategy June 2017

Asia IG is less volatile than US IG

Source: JP Morgan, Asia Credit Outlook and Strategy June 2017

There are four key reasons why the volatility for Asian Investment Grade Credit in particular has been so low compared to other segments of EMD:

  1. Fundamental Growth – higher rates of growth and a more rapidly diversifying economic base
  2. Technical factors – local capital formation and the rise of the “local bid” – Asia owns >75% of its own debt
  3. Credit Quality – the average credit rating for Asia is 1-3 notches above that other EM regions
  4. Credit Metrics – net leverage for Asia IG firms has declined, whereas other EM regions are more stretched

Fundamental Growth – Asia is the fastest growing region in the globe (IMF forecasts growth of 5.5% in 2017 vs 4.5% for EM total1). Asia also is home to the world’s second largest economy and greatest growth engine: China. China is both a key source of issuance and a key source of local capital for the region (especially given its high savings rate). Like Japan before it, the rise of China is having a “flying geese” effect – driving growth in other regional markets.

Technical Factors – Unlike Latin America, which only own 11% or its own debt issuance, or the Mideast, which owns 37%, Asia investors own 75% of their own debt, which has helped dampen volatility in the market significantly. Much of this investment (42%) in new issuance is coming from Chinese banks, but other countries are also key investors (Malaysia 27%, Hong Kong 20%).

Allocation in to EMD by Region

Source: JP Morgan, February 2017

Source: JP Morgan, February 2017

Source: JP Morgan, February 2017

Credit Quality – Linked to the fundamental growth story and market diversification is the emergence of many new investment grade issuers in Asia. In 2006, only 90 issuers could access Investment Grade markets on the JACI index, while in 2016 there were 251. As the recent upgrade of Indonesia to investment grade shows, the integration of more Asian countries in global supply chains has allowed them to increase their credit quality.

Credit Metrics - Relative to other Emerging Market regions, such as LATAM, EM Europe and the Middle East, net leverage for Asian Investment Grade debt has declined since 2013 as investment grade companies have built up their liquidity buffers. Coupled with a lower reliance on external demand, the lower net leverage means that Asian IG Credits are better protected against a downward correction in EMD.

Credit Metrics for EMD Issuers by Region

EM Corporate gross leverage trends

Source: JPMorgan: Smooth Sailing So Far, But Beware of Uncharted Waters, February 2017

EM Corporate net leverage trends

Source: JPMorgan: Smooth Sailing So Far, But Beware of Uncharted Waters, February 2017

What is the Trade-Off for US Investors?

There are two clear costs to re-allocating defensively from higher beta segments of Emerging Market Debt, and making a separate allocation to an Asia Credit Investment Grade fund:

More moderate returns – JACI Investment Grade has returned 4.0% YTD 2017 which is below EMBIG at 7.1% and CEMBI Investment Grade at 4.4%. If we break down the CEMBI index, EM Debt from LATAM Investment Grade has returned 6.5% and EM Europe Investment Grade has produced 4.9% while CEMBI Asia IG has only returned 3.6%. However, over the same period the US Agg has only delivered 2.27% YTD June 2017.

Diversification benefits - As the chart below shows, there are some diversification benefits from Asia IG for a US investor, but the correlation is not as low as for CEMBI (52% on 5Y basis). There are two key reasons for this:

  • at a fundamental level, the integration of Asia into global supply chains means it is more closely tied to the US
  • as Asia Credit within JACI is USD denominated and benchmarked off of US Treasuries – these also drive closer correlations (82% on 5Y basis)

However, as the rolling correlations chart below shows, there are clearly different drivers to the Asia Credit market from the US (as the period from mid 2011 to mid-2013 shows). As regional sources of demand continue to diversify we would expect the correlation with the US Agg also to decline. Both through trade and domestic diversification, China is shifting from export led growth to domestic consumption and now accounts for nearly 20% of regional exports2. The growth in commercial services trade within the region – particularly in areas such as tourism, healthcare and education – should also drive diversification away from commodities and manufacturing.

Downside Correlation of JACI Investment Grade and US Aggregate

Source: Nikko AM, Bloomberg, 28 April 2017

Even with more moderate returns and higher correlations than Global EMD indices, the low volatility and higher returns of Asia Credit Investment Grade does deliver a more efficient investment frontier for US investors. As the scenario chart below shows, using a 50/50 weight of Asia Credit Investment Grade and US Agg, based on historical 3-year returns and volatility, a US investor would see a yield pick-up of 111 bps (from 2.66% to 3.77%), while volatility would only increase by 3bps (from 2.97% to 3.00%). By comparison, if the investor were to simply allocate 100% to US Investment Grade, he or she should expect a marginally lower return 3.61% at a much higher cost in terms of volatility, at 4.13%. Hence, as a defensive repositioning, it makes more sense for a US investor to make a separate allocation to Asia Credit Investment Grade than to divest from EMD completely and re-allocate to US Investment Grade.

Efficient Frontier of US Aggregate and Asia Credit – based on 3Y return / risk

Source: Nikko AM, Bloomberg, as of April 2017

Conclusions

The benefits of a separate allocation to Asia High Grade within EMD include:

  • As with the broader Emerging Market universe, the dynamics of the Asia Credit universe are also very diverse. As economies within the region mature, unique country factors play a greater role in determining returns and US investors can expect greater divergence in business cycles and increased diversification.
  • A selective allocation to Asia IG offers US investors a good defensive position within the EMD universe. There is some trade-off in terms of returns and diversification against a broad EMD exposure, but it significantly reduces the downside volatility exposure that comes with high beta EMD regions.
  • From a long-term perspective, the fundamentals of Asia Investment Grade support “quality yield” pick-up, while ongoing development will continue to drive growth and diversification of USD denominated IG debt within the region.

Footnotes

  1. Source: IMF Forecasts April 2017
  2. Source: World Bank Group: Diversification, Growth and Volatility in Asia-Pacific, July 2015