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Why Asian corporate bonds can make your portfolio more efficient

Schroders analysis found that allocating to Asian corporate bonds, with their attractive yields and relatively low levels of risk, backed by solid country and company fundamentals, can improve portfolio efficiency.

12.03.2019

Roy Diao

Roy Diao

Head of Asian Fixed Income

Investors looking to enhance the performance of their portfolio without taking on too much added risk would be unlikely to go to Asian corporate bonds as their first port of call. But according to analysis from Schroders, an allocation to Asian corporate bonds (bonds issued by companies) can have considerable risk-reward benefits.

The large fluctuations in Asian equities and currencies, coupled with the steady stream of headlines on the potential risks around China, can tend to give an impression of the region’s markets as somewhat unstable. Where corporate bonds are concerned, this is certainly not the case.

Asian corporate bonds have exhibited an enviable balance between returns, yield income and risk over time. These dynamics have been underpinned by strong fundamentals. At a country level, Asia displays encouraging long-term growth drivers, which are solidifying, as well as the added assurance of prudent public finances and high savings. The corporate sector itself is highly cash generative and has a low level of debt.

Asian credit’s role in efficient asset allocation

Schroders undertook research to see what asset allocation would achieve the highest returns, while keeping volatility (the degree to which returns would fluctuate) to a minimum. In other words, to establish what would be the most efficient portfolio.

The analysis tested different asset allocation compositions, in euro terms, setting parameters to reflect the broad allocation levels European investors would typically consider holding across fixed income sub-asset classes.

The parameters were 40 to 60% in European government bonds, 10 to 40% in US Treasuries, 5 to 20% in each US and euro investment grade (IG) corporate bonds, 5 to 20% in each US & Euro high yield (HY) corporate bonds and up to 15% in each emerging market and Asian corporate bonds.

We tested the various asset allocation configurations in the context of market returns and volatility over the past five years. We found that the most efficient possible asset allocation could have achieved annualised returns of 6.0% versus annualised volatility of 3.4%. The portfolio would comprise the following allocations:

- 40.0% European government bonds

- 10.6% US Treasuries

- 5.0% US IG Corporate Bonds

- 5.0% Pan-Euro IG Corporate Bonds

- 15.0% US HY Corporate Bonds

- 12.6% Pan-Euro HY Corporate Bonds

- 11.7% Asian Corporate Bonds

*In euro terms, US Treasuries and IG corps euro-hedged

In terms of the inclusion of a more than 10% allocation to Asian credit (in euro terms), this is not so surprising since it has exhibited clearly low levels of volatility in the past and attractive risk-adjusted returns.

Aside from looking at what would be the most efficient allocation, the analysis also looked at how to allocate to achieve higher returns, above 6%, while still taking on the least amount of extra risk. The analysis showed that to do this would involve increasing exposure to US and euro HY and Asian corporate bonds.

Asian investment grade (IG) corporate bonds in aggregate continue to offer good value relative to other markets, with a wider credit spread than either US IG or euro IG but the same credit rating. In other words, ratings agencies regard Asian corporate bonds to be no more risky than US or European corporate bonds, but the market still prices them as if they are.

As at 31 December 2018, the option adjusted spread (the difference between yields of a corporate bond and the maturity equivalent government bond) on the Asia IG Index was 183 basis points (bps), with duration[1] of 4.8 years. This compares to a spread of 159bps and duration of 6.9 years for the US IG market; implying good potential upside in Asian bond prices (narrowing of the spread) should the spread level start to converge to other markets. 

Corporate bond characteristics

source: Schroders, Bloomberg, ICE BofAML, JP Morgan (for EM indices) as at 31 December 2018. * Hedge costs based on 1 month forward points of the EURUSD swap curve as at 31 December 2018 (2.97%).

** Average rating for all markets except EM based on ICE’s composite rating methodology. Ratings for EM markets based on JP Morgan index rating methodology.

Looking more closely into corporate fundamentals, we see a helpful picture. The margin of EBITDA (earnings before interest, tax, depreciation and amortisation) shows the level of EBITDA as a proportion of total revenue. The higher the figure, the less company revenues are being used to cover operating expenses. This gives an indication of how healthy corporate cash flow generation is and how able companies are to continue to meet interest and debt repayments.

At present then, by this measure, Asian corporates look to be in a healthy position. Additionally, leverage (the ratio of debt to equity) fell below 1.5x last year, declining from 1.9x seen in 2014, and comparing to 2.9x in Europe and 2.3x in the US (JP Morgan estimates).

Asia EBITDA margins still in improving trend

Asia IG corporate leverage relative to US and Euro IG

Asian macroeconomic story remains positive

It’s fair to say some of the heightened exuberance seen around emerging market growth has been tempered over the past decade or so. For Asia, concerns around China, the ongoing moderation in its economy as well as trade tensions with the US, often loom large.

But investors ought not to lose sight of the fact that collectively Asia remains one of the fastest growing regions in the world with increasingly solid longer-term drivers.

Asia has the largest share of the world’s working age (16-64) population. China’s share of the working age population, while declining from 2000’s high of around 23%, is now second largest at just over 20%, while India’s working age population too is substantial. As of 2018, it is the rest of Asia, excluding China, India and Japan, which has the largest share and this is expected to increase over the coming decade or so. 

Additionally, a growing middle class is driving consumption growth. Retail sales in Asia have grown at above 5% over several years, well ahead of the rest of the world. As such, Asia is seen by many as undergoing a rebalancing, away from the more volatile economic model predominant in the past, which depended on commodity exports and low-cost manufacturing. The number of tech start-ups is also rising.

Asian countries among top 20 contributors to global GDP growth

Low risk country fundamentals (particularly for bondholders)

Asian countries have a high level of savings, so are generally less dependent on financing from international markets and therefore less exposed to sudden shifts in investor sentiment which can result in sudden withdrawal of capital. They also have substantial foreign currency reserves, in part reflecting a more prudent approach in view of lessons learned from the late-1990s financial crisis. These characteristics ought to make Asian countries better able to weather difficult periods. 

Forex reserves of Asian countries

Source: Cornerstone Macro September 2018

Another factor pertinent to bondholders is Asia’s broadly low and stable inflation rate. This lowers the risk of interest rate rises regionally, which is supportive for bonds. 

Asian inflation has been low and stable

Asia remains an attractive destination for investors looking for income and returns on capital given the positive fundamentals of the region’s economies and companies. Based on our own analysis, we believe a material allocation to Asian corporate bonds can play an integral role in enhancing risk-adjusted returns in a portfolio. 



[1] Duration indicates the percentage amount a bond price would rise or fall for every 100 basis points (bps) its yield rises or falls. Bond prices move inversely to yields.

 

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Alexander Prinz von Hessen

Alexander Prinz von Hessen

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