Opportunities aplenty among Asian investment grade bonds

ASIAN corporate bond markets have declined year-to-date but we are upbeat about the prospects of investment grade (IG) credits. In the period from the beginning of the year till March 13, the average option adjusted spreads (OAS) on Asian high yield (HY) bonds widened by 311 basis points (bps), while the average credit spreads on Asian IG bonds only increased by 71 bps. From a total return perspective, Asian US dollar IG bonds outperformed HY and remained positive as they registered year-to-date (YTD) returns of +1.05 and -5.44 per cent, respectively.

We think falling benchmark rates are part of the reason for significantly higher credit spreads. After two emergency rate moves by the US Federal Reserve on March 3 and March 16, the target range for the federal funds rate is now 0.00-0.25 per cent. Following the March 3 announcement, the central bank will continue to purchase Treasury bills until at least the end of June, and conduct overnight repurchase agreement operations at least till end- April.

The aftermath following the unexpected rate move on March 16 was a sharp spike in the federal funds April futures contracts. The sudden rate cuts were likely in response to weak financial conditions that deteriorated to the worst level since 2009. Bid-ask spreads on 30-year US government bonds, for example, had widened, and market concerns over trading conditions in Treasuries were rising, which could have led to systemic concerns in credit markets.

With rates at near zero, the Federal Reserve will likely use quantitative easing as its primary tool to boost money supply and encourage lending. As disclosed by the Fed, the bank will increase its Treasury purchases by at least US$500 billion and agency mortgage-backed securities by at least US$200 billion.

Wider credit spreads have also been driven by fund outflows and credit rating downgrades. Fund flow information tracked by Bloomberg showed that corporate fixed income exchange-traded funds registered US$6.02 billion of outflows in YTD March 13. Fund flows reversed to a net outflow of US$3.67 billion in February and a further outflow of US$3.56 billion in the first two weeks of March. The selling activity by funds likely pushed down corporate bond prices, lifted bond yields and created wider credit spreads.

Rating downgrades were another driver of widening spreads. Credit rating agencies were quick to downgrade Asian issuers as many companies lowered their 2020 sales guidance in their Q4 2019 reports. S&P Global Ratings for instance, downgraded 11 issues in January, 15 in February and seven in early March. Moody's Investors Service was by far more aggressive in its downgrades as it cut ratings on 19 issues in January, 20 in February and 11 in early March.

Rating outlooks are an important driver of IG performance as nearly half of the universe teeters on a borderline BBB-equivalent rating. Further downgrades from the rating agencies may ensue, especially when companies provide more colour on the downside impact from the coronavirus outbreak. While we think a further spike in rating downgrades is less likely at this juncture, that scenario would push more names into the HY arena; and volatility along the BBB-rated curve would increase further. To avoid being caught in a potential volatile spot in the market, we think IG investors are better off investing in credits with rating equivalent to at least A-.

We think corporate IG bonds are now attractively priced along with the substantial jump in OAS. The rolling one-month difference in Asian IG OAS soared to +71 bps as at March 13. When the OAS change was at this level in September 2011, Asian IG bonds rallied 11 per cent in the immediate 12 months thereafter.

Broader macroeconomic factors caused spreads to widen in 2011 as Europe was in the midst of a debt crisis. Greece had difficulty repaying its creditors, and there was a strain in funding markets due to concerns about sovereign debt. Soon after, the financial market situation improved when six major central banks jointly announced the establishment of swap lines to enhance cross border liquidity.

That scenario may not be too far off from the current spate of affairs. The G-7 monetary authorities including Australia, England and Japan have intervened to ease liquidity conditions, but corporate bond yields have continued their upward trajectories. While credit spreads may still widen further depending on how the Covid-19 situation evolves, we think the indiscriminate selling in the past month has provided buying opportunities.

In spite of the heavy negative news flow and prevailing risk-off environment, total YTD returns for Singapore dollar (SGD) IG corporates have stayed positive. Based on data from Markit iBoxx, the sector was up 3.37 per cent YTD from a total return perspective. SGD bank corporate papers returned 0.24 per cent, while SGD real estate IG posted a total YTD return of 0.82 per cent.

Credit profiles of SGD issuers were largely stable in 2019. Our survey of 76 corporate non-financial SGD issuers showed that their aggregate gearing profile, represented by total debt over total assets, remained at nearly the same level at the end of both 2018 and 2019. Total revenue of the 76 issuers increased 2 per cent to S$597 billion during 2019 but total net profit dropped 22 per cent on the year to S$45 billion.

Bank issuers of SGD fixed income securities lost 0.3 per cent in revenue during 2019. Total net profit declined 8 per cent to S$205 billion, while total equity was flat at S$29 trillion. Singapore banks performed better than their foreign peers as they posted double-digit growth rates in revenue. Singapore banks remain well capitalised, and we think there is a strong likelihood of sovereign support in times of need. Common Equity Tier 1 ratios, a measure of capital adequacy, were 14.9, 14.1 and 14.3 per cent for OCBC, DBS and UOB respectively at the end of 2019 - well above regulatory requirements.

Broadly speaking, we think that Asian IG is likely to outperform HY moving forward as we expect a divergence in bond yields between the two markets, with the weak macro outlook likely driving investors to seek safety in sovereign and strong IG credits. However, our recommended strategy in IG investing is a bit nuanced, as credit selection is key against this fluid and fast-moving market backdrop. Central banks and governments may continue to roll out monetary and fiscal stimulus measures in response to downside macro risks posed by the coronavirus market turmoil. These economy-boosting measures will benefit both HY and IG issuers, but the latter would enjoy better access to funding markets given their sounder financial standing.

Investors seeking to tap into the potential upside of investment grade bonds may consider the DBSSP 3.800 per cent Jan 20, 2028 Corp (SGD); CAPLSP 3.800 per cent Aug 28, 2024 Corp (SGD); and SIASP 3.030 per cent March 28, 2024 Corp (SGD) - Retail.