Credit markets could be first to rebound

Asian companies are betting that credit will offer the best returns in 2009 and, like the smart traders they are, executives in the region are busy buying back their debt with gusto. Earlier this week, Nine Dragons Paper bought back the remainder of a $300 million bond due in 2013, offering to pay 53 cents to the dollar, and other Asian borrowers retired a total of close to $2 billion in 2008.

Such trades look like good bets. Right now, bonds are paying equity-like returns for credit-like risks. According to credit analysts at Morgan Stanley, corporate bonds rated triple-B are now paying real yields of more than 9%. Compare that with long-term real returns of just 6.8% on stocks or 1.2% on government bonds. Optimistic forecasts for US equities in 2009 predict a maximum 8% rise, while bearish predictions forecast that US equities could halve in value.

The credit markets were the first to suffer in the early stages of this down market and will be among the first to improve, which is why Morgan Stanley is calling 2009 "The Year of Credit".

The fallout from Japan's banking crisis offers clues to how the current situation may resolve itself. Back then, healing started first in the areas that had been most affected -- interbank lending recovered earliest, followed by credit markets, volatility markets and finally, many years later, equity markets.

In today's crisis, interbank lending is already starting to recover. The spread between three-month interbank lending rates and overnight rates, which provides a key measure of the health of credit markets, has dropped significantly from its peak of 364bp in early 2008 down to less than 100bp today. As the interbank market recovers, credit should be next to heal.

However, at the moment, triple-B spreads are at their highest levels in more than 100 years, which makes credit look like an extremely attractive investment opportunity. And there is every reason to expect that Asian corporates will participate in the healing, perhaps even as quickly as their counterparts in the US.

"This is not an emerging markets crisis, it's a sovereign crisis," says Viktor Hjort, a credit analyst at Morgan Stanley in Hong Kong. "What we're seeing is a transfer of risk out of the private sector into the sovereigns. It's a very broad sovereign issue."

The credit markets bear this out. During the crisis, spreads on Italian sovereign debt, for example, have widened more than on Indonesia's debt. And, unlike in 1997, Asian corporates are in a strong position this time -- by the second quarter of 2008 they had halved their debt levels compared to December 1996, and more importantly, are now much less reliant on short-term funding. Morgan Stanley says that most investment-grade companies in Asia can comfortably survive without new funding until 2010, and much longer if they cut discretionary spending plans.

As a result, investment-grade Asian corporate bonds are in high demand but in short supply. Issuance from Asian non-financials fell 40% in 2008, compared to an increase in the US and a tiny drop in Europe.

Indeed, instead of selling new bonds, many companies are buying their bonds back to boost their returns. "The IRR [internal rate of return] of buying back debt is way higher than capital expenditure or buying back shares," says Hjort.

Given the liquidity of their balance sheets and current return on equity, Morgan Stanley reckons that companies such as Galaxy Entertainment, Hutchison Whampoa and KCC Corporation have good incentives to continue buying back their debt -- which means that new Asian corporate issuance is likely to remain weak during 2009, at least from investment-grade issuers.

High-yield borrowers find themselves in a different environment. It is still too early to be bullish on high yield, says Morgan Stanley, and Asia is likely to be the last junk market to recover. As Hjort says: "In the investment-grade space, the sellers are on strike, and in high-yield, the buyers are on strike."