In the first in a series of interviews with fixed income research heads, UBS Warburg's Stephen Cheng talks about his firm's approach and the best calls they have made this year.
What have been the major trends in fixed income research in the past year?
It's important to recognize that the fall in interest rates has meant that a lot more investors have been looking for incremental yield. So we've seen a lot more investors coming and asking questions about investments lower down the credit curve. So from a trend perspective, I have been looking more at the sub-investment grade category. Two years ago investors were more focused on high grade names. Now they are focusing more on improving the yield in their portfolios, with credits where they can more reasonably assess the risk-reward ratio.
So does this mean you are shifting your internal resources away from the high grade credits and more to the sub-investment grade?
Definitely. In the past, in a country like Korea there would a lot of maintenance coverage of high grade names like Kepco and Korea Telecom. But now we seldom look at that part of the credit spectrum and are looking at names such as Kia Motors, and Hynix, because that's where the interest is. Similarly in Hong Kong, there has been much less interest in the KCRCs and MTRs and more on the high yielding Chinese infrastructure plays such as Road King. So now 70% of our time is focused on the sub-investment grade category.
The value in high-grade now is questionable. A lot of people look at the high grade names as more defensive. But I think investors want incremental yield now.
Do you enjoy writing more about these sub-investment grade credits, where you can really say what you think without upsetting the investment banking department?
From a credit perspective, you are more challenged, in terms of really pulling these companies apart, looking at the cashflows and value drivers in that company, and knowing that yields could swing either way quite quickly. That's where the real interest comes as an analyst - trying to catch the trend. When you are talking about high-grade credits, it's more about relative value and macro-calls, and what you feel the country's fundamentals to be and the technicals of the way it trades. For the higher yielding credits you are often removing the macro concerns and really focusing down on the core values of the credit.
Does the appetite for these high yield credits come mostly from the US?
I would say 70% of it comes from the US and Europe, but increasingly we've seen Asian investors becoming a larger player. We've seen several instances where private banks have set up funds wholly dedicated to looking at high yielding assets, and likewise we have seen banks who have removed restrictions so that they can look at credits below investment grade. Increasingly, we're seeing banks move away from investing in not just senior debt but sub-debt in the banking sector. So throughout Asia the investor base is gradually moving down the credit curve and looking for yield.
Do you worry that some investors are taking too much risk and not getting enough reward in this climate of low interest rates?
I don't see that problem just yet. One key issue this time around is we're not seeing a lot of new issuance; they're buying existing names a lot of the time or recovery plays. As you know, liquidity still remains extremely strong and what we are seeing is the balancing of portfolios, rather than an outright shifting of portfolios into an aggressive stance. If we start seeing high yield deals being snapped up left, right and centre, then maybe you start worrying.
What's your view on Hynix?
We're still pretty scepical. It all comes back to the fundamentals. The industry outlook remains so pessimistic, and the recovery is probably not expected till the second half of next year - the question is, how long does this latest bailout last before they come back to the markets again. Some people are looking at some of the bonds, and will raise the view that there is a recovery play on the assets, given you are talking about secured assets in the US. But the problem for me is how do you really value an asset in an environment of excess capacity - to make it operational, you are actually losing money. So we're still cautious. We still feel a more meaningful type of restructuring or receivership situation is inevitable.
Apart from the sub-investment grade trend you mentioned, are we also seeing more research on bank sub-debt?
Yes, certainly. We are going to see ongoing consolidation in the banking sector - whether within country or intra-regional acquisitions. And some of these will be financed by bank capital market securities, or sub-debt will be used to rebuild capital bases if asset quality problems start to rise again. Sub-debt in the region is a new instrument, and we do expect the volumes to increase going forward. And likewise, we'll expect to see more Asian investors participating in sub-debt. Increasingly, they're recognizing that a lot of the potential for new issuance is not coming from the corporate sector but from bank sub-debt. And if you don't change your mandate to allow for investment in this area, then there is going to be very limited opportunities for you. And indeed, Asian bank sub-debt still trades a lot cheaper than its US and European equivalent and so offers value. That's not the case if you look at the corporate sector. One reason for that is you have not enjoyed the same technicals. Corporate credit spreads have been driven tighter by strong regional demand; but because the region has been more hands-off in its approach to sub-debt, you see better incremental value relative to its European or US counterparts. So providing more research on sub-debt makes sense.
What are the calls you've made this year that have made your clients money?
One thing we realized this year was that fundamentals played less of a factor in driving credit spreads. A lot more is driven by technical situations such as who is buying. If you got that right you did well. For example, if you knew in Korea that there was strong liquidity onshore and that an arbitrage existed for buying dollar based assets and swapping back to Korean won, you would have recognized that there was an inherent domestic bid that would be very strong, and if you played that trade right it proved to be very rewarding, as well as defensive within the overall environment.
It was also important to recognize that with fundamentals being less of a concern, every time you had technical uncertainties that were driving spreads wider, that was typically a buying opportunity. So, for example, back in July when there were concerns about new supply and PCCW was trying to issue, there was a general spread widening that was based on technical concerns, and our strategy was to buy high-grade or benchmark names on dips and throughout this year that was probably the right strategy.
Is there a sub-investment grade credit you picked that performed well?
We've liked the Chinese infrastructure plays. So names we've liked early were the likes of Road King, and GS Superhighway. Those have been some of the best performing sub-investment grade credits. They are trading close to par now, but at the beginning of the year, when we started calling them, they were in the mid-80s. We felt the underlying growth and cashflow assumptions were not too aggressive and yet the domestic environment was manageable. Technicals affected those bonds more than anything else, because there was still fear about the Itic sector.
We also recommended the restructured GDE debt early, GH Water. That was a bond that we recommended when it was in the mid-60s and it is now close to 90.
So in terms of high yield plays, China has been one of the top performers this year.
