Dear readers, today I am sharing a write-up by someone who is specialised in Bonds/ fixed income. Previously, he was a bond research analyst with one the financial institution in Singapore. I thought it is very enlightening into the Asian HY space and hope it will be helpful to you.
Asian HY bonds have taken a significant beating so far in 2021, but this is also a tremendous opportunity for investors. Let me explain why:
China real estate bonds are weighing down on Asian HY bond returns
Asian HY has been hurt primarily by Chinese real estate bonds; the chart shows the significant surge in bond yields for the sector following the China Evergrande debt crisis; these are levels not seen since the depths of last year’s crisis (at least for BB China real estate bonds). Single-B China real estate bonds are trading even wider.
If we drill down into the Asian HY index, we find that investors have sold off China real estate bonds quite indiscriminately – as of 10 Nov 2021, the average cash price of China HY bonds was 59 cents on the dollar (Bloomberg Asia USD High Yield Diversified Credit Index). Outside of the China real estate sector, the average cash price of Asian HY bonds is actually 98 cents on the dollar, which suggests that stress is primarily coming from the China property space.
How much downside from here?
To forecast downside risk, let’s first assume a worst-case scenario where all China HY real estate bonds were to default. In this unthinkable scenario, we can price all China HY real estate bonds at 30 cents on the dollar, which would represent a fairly conservative recovery rate (based on historical recovery rates in prior defaults/restructurings, this is probably too conservative). Given that China real estate now makes up around 20% of the Asian HY index, re-pricing the sector to “defaulted” levels would suggest a further halving of the sector, or a further -10% downside. Again, this is a worst-case scenario and I don’t think anyone truly expects this to happen, but this hypothetical situation provides some basis for how much more Asian HY bonds can decline from current levels.
How much upside from here?
As of 9 November 2021, the YTM on Asian HY bonds was around 11%, which provides some guidance on longer-term returns. With a current yield of around 7% p.a., a 3.3 year duration and a spread of 1,007.5 bps, we can estimate a normalisation of spreads to 5% over a 3-year period (still slightly higher than historical averages). This would result in a spread compression of around 500bps, or +16.5% (5% x 3.3) over 3 years, or 5.5% p.a. Adding a 7% p.a. current yield, this would bring total returns to 12.5% p.a. over the 3 years, before factoring in defaults. From this, we can say that if default rates average 2.5% p.a. or less over the next 3 years, investors will still be able to achieve a 10% p.a. return in Asian HY. Any higher, and this can be subtracted from that 12.5% p.a. return for a forecast of actual returns going forward.
In practice, spread normalisation doesn’t happen so gradually, but credit spreads can tighten very quickly once risk appetite improves. If spreads narrow by 500bps over the next 12 months, this will contribute a 16.5% return, plus 7% current yield, for a 23.5% total return before considering defaults. Consequently, even if default rates were to jump to 10% (which would be the worst levels on record; historical average is around 2% p.a.), this would still be a decent 13.5% return over a fairly short period.
Who should buy Asian HY today?
There are clearly a lot of policy risks involved for China real estate at the moment which has contributed to the negative sentiment and weak bond prices, along with some defaults (and impending restructuring cases). If you buy Asian HY today, you should be thinking along these lines:
- I don’t expect the entire China HY real estate sector to default, even though the market seems to be trying to price companies for that kind of outcome.
- At some stage, banks (and private investors) will start lending to the real estate sector again, which will help most of the companies get through this difficult period. This could be policy-driven (China attempting to stem off a systemic crisis of liquidity for China real estate developers), or investment thesis-driven (i.e. good companies have been thrown out with the bathwater, and it is an opportunity for savvy investors to finance the companies at great terms, with attractively-priced equity or high interest loans/bonds), or likely, both.
- Even if the worst-case scenario happens and all the China real estate developers default, my downside risk is likely capped, as the sector’s exposure within Asian HY has fallen (along with falling bond prices).
- I’m prepared for the eventuality that default rates will rise, but credit spreads are already so wide and have more than factored these expectations in, so I’m comfortable that even if we see further defaults in China real estate bonds going forward, this shouldn’t make a significant dent on my Asian HY investment.