High yield

2020 G3 DCM: Where's the upside for high yield?

Investors may need to display more cunning to navigate the Asian high yield bond markets during 2020 as the approaching Year of the Rat ushers in a heavy pipeline of redemptions.

It has been an explosive year for Asia’s high yield bond markets with the region’s record-breaking $93 billion issuance surpassing Europe’s $87 billion equivalent for the first time ever.

The achievement is all the more impressive given that Asian volumes have risen nearly 150% this year largely thanks to the huge financing appetite of China’s high yield real estate borrowers. Investors have also had a good 2019, recording low double-digit returns in Asian high yield, their best year since 2012.

In the end, the Year of the Pig has turned out to be true to its name. It has been a year marked by luck and good fortune.

The second half of the year, however, has been characterised by more volatile spreads, with the Bloomberg Barclays Asia High Yield Index re-tracing about 100 basis points of its performance since June. As the year draws to a close, it is clear that the supply deluge has impacted relative spread performance since the investment grade/high yield differential remains over 400bp compared to nearly half that level at the end of 2017.

Next year, will be the Year of the Metal Rat. In the Chinese zodiac, rats are well-liked, positive and confident creatures.

Deep down, however, they are often troubled by worries of their own making, which ties in with one of the main fears for 2020 – a spike in defaults if growth slows.

So where does that leave borrowers and investors as they move into 2020? Over the past couple of weeks, FinanceAsia has been canvassing the sell-side for their views and in this article, we examine forecasts for China’s all-important high yield sector.

LOWER ISSUANCE

What comes out is a very clear consensus that issuance is likely to be lower because of a change of policy at China’s National Development Reform Commission (NDRC).

Conan Tam, co-head Asia Pacific debt solutions, BofA Securities, sums up for his peers when he states, “It’s a pretty mathematical calculation. For most of this year, the NDRC has been very liberal with quotas. Right now it’s far more stringent and that will provide a natural cap on issuance levels.”

Real estate issuers’ offshore activity has been restricted to re-financing their offshore debt, while local government financing vehicles (LGFV) will be examined on a case-by-case basis and only allowed to issue if the proceeds are used for projects that assist the real economy. Together, these two segments accounted for just under half of Asia’s overall high yield issuance in 2019.

Unless the NDRC’s policy changes – and it could well do before next year is out – then it is unlikely that 2020 will top 2019. Bankers report that the real estate borrowers have used up every drop of their existing quotas and more, which suggests a much slimmer pipeline.

Where LGFV’s are concerned, one banker at a Chinese securities house told FinanceAsia that, “there will be a lagging factor since a number of LGFVs either still have quotas outstanding, or were in the process of applying when the new guidelines came in. So this drop-off in issuance won’t really kick in until the second half of next year.”

In the meantime, restricted supply is one of the main reasons why one credit research analyst after another is flagging a preference for high yield over investment grade credit in 2020.

LOWER RETURNS

UBS says it has “a bias towards high yield over investment grade with some compression opportunities”. It is forecasting returns of 6.2% over the course of the year.

Likewise, Morgan Stanley recently upgraded Chinese high yield property to overweight. Credit strategist, Kelvin Pang, says that “if trade tensions recede and we enter a mini-cycle recovery in the first quarter of 2020, it should be supportive of spread tightening in Asia credit next year, driven mainly by spread compression between high yield and investment grade.”

Dilip Shahani, HSBC’s head of global research for Asia Pacific, also believes that high yield will get a favourable re-rating from lower gross and net issuance compared to 2019. He also thinks the China bid for offshore credits will start to kick in from the second half because anticipated Chinese monetary stimulus will make domestic financial income assets start to look expensive.

But not everyone agrees. Owen Gallimore, head of credit strategy at ANZ in Singapore, recently wrote that he was bemused by the “apparent market consensus bullishness for high yield in 2020 given the destabilising default precedents.” He calculates that China’s offshore universe of distressed dollar credit grew from $15bn to $63bn in 2018, and remained high at $57bn in 2019.

Every Asian debt capital markets (DCM) participant is also aware that there is a very heavy redemption schedule over the next three years because of the high yield market’s short duration bias.

Tim Fang, head of global markets, AMTD, says the market will need to stay open to manage the wave of re-financings coming due. “The absolute peak is 2021,” he commented. “But some borrowers have already pre-empted this with their refinancing activity and that’s taken some of the pressure off.”

He thinks the market might be “a bit more challenging for new names particularly if they don’t tick all the right boxes, which includes being rated and having a stock market listing.”

Haitham Ghattas, head of Asia Pacific capital markets at Deutsche Bank, highlights the structural step forward that Asia’s high yield bond market has taken in surpassing Europe.

“The sheer amount of capital being raised has made high yield a regular funding channel for Asia corporates,” he commented. “That’s a positive step, but it does make companies a little more dependent on this market.”

And that strong flow applies to the buy-side too. BofA Securities’ Tam comments that “fund inflows have been strong, so there are going to be a broad spread of investors on the hunt for yield.”

One Chinese investment banker believes this means that it will be a good year for issuers.

“I’m still bullish about 2020 but I don’t think investor returns will be as good as they have been this year,” the banker said. “The NDRC quota restrictions mean a supply/demand imbalance is building up. Supply is coming down at a time when demand remains strong.”

And that demand will be coming from private banking as well as institutional investors. One banker mentioned that he did not know a private banking house "with less than $2 billion in re-investment needs in part because of all the 2014 and 2015 bond deals with call options coming up.”

Yet conversely strong demand for new issues should help contract secondary market yields, creating positive tightening momentum.

Deutsche’s Ghattas also sees more interest from outside Asia. “It’s getting harder and harder for the big global investors to ignore China now that some of the country’s larger borrowers have $7 billion to $10 billion of paper outstanding,” he reflected.

“Even if the latter don’t execute 144a deals, investors can still trade the paper once it’s been seasoned in the secondary market,” he continued. “We also see more investors willing to put larger cheques to work and commit to the credit work on names they haven’t seen before.”

HSBC’s Shahani has a slightly different take, however. In his 2020 Asian credit outlook, he notes a “diminished level of foreign interest, particularly towards the Chinese issuer space”.

He says this, “reflects concerns about future economic performance, corporate governance and disclosure quality, adequate legal recourse in an event of fraud, and corporate restructuring or liquidation.”

DOUBLE-B OR SINGLE-B?

One key question for next year is whether high yield investors will be prepared to move further down the ratings curve to pick up more yield once their performance hurdles are re-set on January 1. Could this narrow the double-B and single-B spread differential?

Here the views are mixed. Some believe that investors will stick to double-B.

“Risk appetite has been increasing, but the overall macro picture is keeping investors cautious,” said one Chinese investment banker. “They’re well aware of rising default risks and their preference is for higher quality double B rated paper.

“I sense they’d prefer to sacrifice a little yield for the additional safety factor,” she added.

Ernst Grabowski, head of Asia Pacific debt syndicate at Morgan Stanley, agrees. “The high double B segment will continue to do well,” he said. “It’s investors’ safe space from all the trade and cyclical headwinds.”

However, Grabowski said that he “can see the logic in the thesis that investors have ridden all the price performance there is in double-B and will be willing to trim positions to move further down the credit curve.”

For example, Nomura’s credit analysts are advocating that fund managers avoid extending duration in double-B names in favour of positioning themselves in shorter-dated single-B names. They cite improved liquidity positions, arguing that leverage will be “contained given their limited incremental funding”.

Kenneth Lee, head of primary bond markets Asia Pacific at Natixis, straddles the middle of the debate. “The feedback we’re getting is that investors are really scrutinising credits,” he stated.

“I wouldn’t be surprised to see some tightening on the spread differential in mid/strong single-B vs double-B trading levels, but investors are being more careful,” he added.

Lee highlights how a fair few Chinese investors were caught off guard by the defaults of the Founder and Tewoo groups during 2019.

“They thought that state backing would protect them from default losses, but that hasn’t been the case,” he explained. “It’s been a sobering lesson about the need to engage in proper credit work.”

BofA’s Tam and Deutsche’s Ghattas both highlight the distinction that investors make between high single-B and mid-to-low single-B credits.

“There’s good interest in the larger single-B repeat issuer credits and investors tend to put them in the same bucket as low double-Bs in terms of the level of interest, said Tam. “These credits are generally well known and have a good consistent following among institutional investors.”

Ghattas adds his view that “B+ is the high yield market’s sweet spot. These yields are still quite attractive and the credit quality is acceptable.”

“The notable bifurcation is between B+ and B trading levels,” he continued. “However, investors are looking at B-rated credits even if they’re not buying them en masse yet.”

Over the past year, investors have done very well from some of the market’s better-known single-B names like Hong Kong-listed B2/B+/B+ -rated Powerlong. Its 4.875% September 2021 bond (callable 2020) has tightened from 10.79% at the start of 2019 to 6.4% towards the end.

They are now on the lookout for the next wave of mid single-B names that can notch up to the higher end of the ratings bucket, but may be less well known because they have a shorter track-record in the public equity and debt markets.

Candidates include Redsun Properties, which has a B2/B+/B rating and listed on the Hong Kong Stock Exchange in 2018. Its recently issued 13% October 2021 bond is currently trading around the 11.56% mark.

Deutsche’s Ghattas flags the extreme swings Chinese property credits have been subject to. “Every couple of years, single-B credits sell off to distressed levels and one way or another that’s always proven to be a massive buying opportunity,” he said.

“Investors have ridden that wave this year and we start 2020 in a very different place. As a result, we may see investors deciding to move down the curve to meet their absolute return hurdles.”

DURATION EXTENSION?

Does that mean they will head down the maturity curve as well as the yield curve?

Country Garden showed that it was possible in March when it raised $1.5 billion from a five-year and seven-year bond that won FinanceAsia’s award for Best High Yield Deal of the year. It has, however, a crossover rating of B1/BB+/BBB- and a long-standing following among Asian high yield investors.

Most issuers will find it harder to follow suit as HSBC’s Shahani argues.

In his 2020 credit outlook, he says that high yield corporate issuers are unlikely to benefit from being able to “pursue duration extension strategies as investors may stay cautious because of the still uncertain operating environment.” He concludes that corporate credit curves will remain steep, making it difficult for borrowers to extend down the curve.

One key aspect will be the attitude of Chinese private banking investors.

Derek Armstrong, head of Asia Pacific debt capital markets at Credit Suisse, says they have “remained pragmatic” during 2019. “They’ve been selective, investing in names that resonate with them,” he stated.

AMTD’s Fang reinforces this argument. He highlights the new family offices and securities firms coming into the market all the time.

“They have high yield thresholds and they’re happy to invest in single B names if they know them,” he stated.

Morgan Stanley’s Grabowski, however, says that private banking investors’ “short-dated bias is psychologically-driven not cycle-driven”. He says they “can see how flat the curve is and many of them just don’t think it’s worth extending the duration to pick up a few extra basis points.”

He concludes that “they feel that if they buy one- to two-year paper there’s inherently less default risk.”

Bankers and credit analysts remain sanguine about default risk in the Chinese property sector. UBS argues that although “the property market will not be used a stimulus tool, we think it is unlikely the government will allow a sharp correction in property prices.”

It notes that onshore redemptions in the real estate sector may total $49.5 billion during 2020 given there are $17.7 billion of puttable bonds. This is twice the level of the $25.5 billion offshore bonds coming due.

The sector covered in red flags belongs to industrials credits. UBS thinks that distressed industrials credits will help add one percentage point to the current default level of 1% to 1.5% among Asian corporates. 

But it concludes that overall defaults will be slow in picking up and are already well-flagged.

Credit analysts such as ANZ’s Gallimore are fairly positive about the LGFV sector. 

Nomura says there is a high chance they will remain a safe haven considering the government’s current policy stance.

Bankers believe the sector will continue to be active notwithstanding the NDRC’s current policy stance. A number flag an increase in enquiries for short-dated paper, which falls outside the regulator’s remit, as well as structured products for private banking investors.

One sector, which has not yet caught on among Asian bond issuers are private equity-related deals. Augusto King, head of Asian debt capital markets at MUFG, says, “The leveraged high yield market just hasn’t taken off here yet. It’s still very loan-focused.”

This is one area where Europe is still miles ahead. In 2019, Bloomberg figures show that sponsor-related M&A, leveraged buyout and capex-related deals have accounted for one-fifth of the total.

In the third in this series, FinanceAsia will look at the outlook for issuance from Southeast and South Asia.

 

 

 

 

 

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