Amid tight valuations, stay active in Asian investment-grade bonds
THE Asian investment-grade (IG) bond segment delivered a 7.4 per cent return in 2023 (in local currency terms, based on Bloomberg indices), marking a rebound from 2022, when many bond markets were hit by the sharp pace of Fed rate hikes.
Looking ahead, we think that macro and issuer fundamentals remain robust within the space, but caution is warranted on increasingly tight valuations.
Decent fundamentals
On the macro front, we expect Asia to continue to deliver resilient growth in 2024. This is a view echoed by supranational organisations such as the International Monetary Fund, which forecasts a 4.2 per cent growth for the Asia-Pacific region, and the Asian Development Bank, which forecasts a 4.8 per cent growth for developing Asia.
We think that growth drivers could emerge from markets like South Korea and Singapore, due to their structural comparative advantages over regional peers, and their ability to benefit from tailwinds in the semiconductor industry.
Other interesting markets to look out for include Asean-5 (Indonesia, Malaysia, Philippines, Singapore and Thailand), which may also benefit recovering tourism and longer-term trends like supply-chain diversification. We acknowledge some uncertainty for China, but policy support (both fiscal and monetary) should at least help to support economic growth there.
Inflation also looks relatively manageable and well-anchored across Asia. Inflation figures, as well as inflation expectations as compiled by Bloomberg, have already gone below or within the inflation targets set by central banks in China, Indonesia, and India. This is in contrast to developed markets like the US, where inflation remains persistently above the official 2 per cent Fed target. This indicates that monetary policy in Asia is less restrictive, at least relative to the sharp rate hikes seen over the past few years.
Looking at issuers on a bottom-up basis, we also find that many issuers within the Asian IG space continue to deliver robust growth in revenues and profitability. Leverage ratios have also remained fairly stable as a whole, with no significant deterioration observed on an index level. We think default probabilities remain fairly manageable today, given the decent financial ratios, and this should support the broader performance of the Asian IG universe.
Taking into account both the top-down and bottom-up factors, we think the outlook for Asian IG bonds remains decent.
Tight valuations compared to history and peers
Despite the optimistic macro outlook, we caution that valuations now look fairly stretched within Asian IG. Markets appear to be already pricing in some of the decent outlook. Another factor could be investors reallocating from Asian high yield (HY) into the IG segment due to uncertainty in the Asian HY space, particularly in light of the continued turmoil within Chinese property developers.
Based on our estimates, using Bloomberg indices, the Asian IG Bond index is trading at a spread of just under 90 basis points (bps), well below the historical average of 146 bps. While spreads are certainly tight across many other bond markets as well (relative to their respective historical averages), we find this most acute in Asian IG.
Most markets are trading at spreads of between 0 and 1 standard deviation below historical averages, while the Asian IG market is trading at over 2 standard deviations below historical averages.
To summarise, we think that valuations look fairly stretched, and investors may find it tougher to identify the best credit opportunities with attractive risk-adjusted returns.
How to navigate Asian IG bonds
We think that active credit selection could be the key to unlocking alpha in this environment of very tight spreads. There is no shortage of Asian IG funds in the market. Many funds are helmed by experienced managers, and potential investors may leverage their expertise in credit selection.
Investors who wish to conduct their own credit selection (instead of delegating it to a fund manager) should consider several key factors in their investment decisions. We generally recommend a shorter duration exposure for US dollar and Singapore dollar-denominated bonds, given the currently inverted yield curve.
In addition, it is important to look at each issuer’s fundamentals, such as profitability, liquidity and cash flow, to assess the credit quality of each bond relative to the yield offered.
Final thoughts
Despite our concerns about tight valuations, we highlight that the Asian IG bond market has delivered one of the better risk-adjusted returns (based on Sharpe ratios) over the past 10 years, compared to other major bond markets. The macro backdrop also remains decent for now, which should help support the performance of these bonds.
Our preference is for active management to best take advantage of opportunities in this space, and this can be achieved through unit trusts.
Whether investors decide to delegate the credit selection to an active manager or select their own bonds, we believe Asian IG bonds remain an integral part of a diversified portfolio.
The writer is a fixed income analyst in the Bondsupermart team at iFast Financial, the Singapore subsidiary of SGX-listed iFast Corporation Ltd.
