Mr Tim Jagger, senior vice-president for fixed income for Asia at Aviva Investors, shares his outlook on Asian high-yield bonds in the latest in our series featuring fund managers and leading market experts.
Valuations for Asian high-yield bonds took a hit in the third quarter as investors weighed up an impending rate rise in the United States, said Mr Jagger.
However, he is still optimistic on the sector and expects returns for the next 12 months to be close to 6 per cent.
This is because the aggregate prices of Asian high-yield bonds are at their lowest in three years while default rates for companies issuing these bonds will likely not get relatively high.
Mr Jagger, who is also the lead fund manager of the Aviva Investors Asian High Yield Bond Fund, does not expect the first few US rate hikes to adversely impact high-yield bonds as they will not entail a significant increase in funding costs for business.
There is a point, however, when higher interest rates will start to slow economic growth, he adds.
"Given high-yield borrowers are more susceptible to adverse changes in the financing and economic environment, likelihood of default increases with rate rises at that point," Mr Jagger said.
Q What are the return characteristics of a high-yield bond?
A If you look at the Asian high-yield market since the benchmark was incepted in 2005, you've typically achieved about a 9 per cent annual return. The volatility of these returns is slightly higher compared to the US high-yield market, which has delivered an 8 per cent return or so.
Studies have shown that if you hold a high-yield bond portfolio for over 10 years, you typically get an equity-like return for far lower levels of volatility than investing in an equity market.
Q What are the risks involved in high-yield bond investing?
A There are two key risks. First, the likelihood that the company will default. Second, the severity of loss in the event of a default.
You can generally assess the likelihood of default through quite traditional sort of business and financial analysis techniques. This, however, is slightly complicated by perhaps the lower information disclosure and corporate governance in Asia compared with, say, the US.
Where it gets more difficult in an Asian context is assessing the severity of loss should a company get into financial difficulty.
This is because the transparency of insolvency regimes in many parts of Asia is low. While statistical evidence shows that the severity of loss is very comparable with the developed market environments, variations around that mean can be a lot higher in Asia because of difficulties such as navigating some of the local legal environments.
Q How have you constructed your portfolio to work around the lack of transparency in insolvency regimes?
A We focus on instruments of higher credit quality - the double Bs and single Bs. We tend to be quite selective about investing in triple Cs or investing in the low-quality end of single Bs because at that point, loss severity becomes a far more important consideration.
Q What do you expect returns to be for this particular product?
A Returns for this product in the year to date have been sort of 3.5 per cent, which is quite decent relative to a lot of investment alternatives these days.
We had as high as a 5 per cent total return year-to-date at the start of the last quarter, but obviously we've had a risk-off environment over the last quarter or so.
Currently, our forward-looking return expectation for the next 12 months is 4 per cent to 6 per cent. We are more likely to break out at the top of that range than at the bottom.
Valuations are now the best they've been in about three years on an aggregate basis. They have improved over the last quarter, given the risk-off environment that we have had.
People have been worried about how more challenged borrowers would be impacted by higher dollar funding costs as rates of interest start to rise in the US.
As default rate expectations are not meaningfully higher over the next 12 months, you could actually make a case for being at the top end of that return expectation range rather than at the bottom end.
Q What do you think will happen when the US Federal Reserve raises interest rates?
A We will likely see some volatility in rates but I don't think it will impact the market the same way it did in 2013.
In 2013, the taper tantrum - the period of volatility that occurred when investors thought a rate rise would occur soon - was likely mostly retail-investor driven. In late 2013, what retail investors sold was effectively bought by investors.
This year, we have not seen the volatility that we saw in 2013 as the institutional participation rate is higher and such investors tend to have a longer-term view .
What's more important for me is almost not when the Fed raises rates, but the communication around that rise.
Q How have investments in China been affected by recent volatility in the market?
A In the Asian high-yield context, China has massively outperformed over the last few months.
The market that has been most badly affected has actually been Indonesia because it's seen as more vulnerable to an increase in dollar funding costs. China is more insulated from that.
The China high-yield market consists of a lot of cyclical companies which are benefiting from the pro-cyclical policy settings that the Chinese authorities now have in place, such as falling onshore interest rates and stimulus packages.
Q Why are you overweight on the Chinese property sector?
A Property companies can increasingly issue bonds in the local onshore market because of regulatory changes.
Cost of funding in the Chinese onshore market is lower than that of the offshore market. For instance, in the case of a large player in the China property market, its offshore bonds were trading at a 12 per cent yield when it issued an onshore bond of the same maturity at 6 per cent yield. The coupon paid on the onshore bond is also tax-deductible. These savings cause the interest cover and other metrics to look better.
When companies issue more onshore bonds, they also will decrease the stock of US-dollar-denominated securities issued in the future.
This causes a higher rarity pre-mium to be attached to their US-dollar securities.
Three or four years ago, some property companies perhaps saw meaningful upside in land values in the short term and were very aggressive in acquiring land.
Now they're not buying as much land and are focusing more on selling existing inventory.