What will be the key macro trends for Asian fixed income this year?
The past two years were the most volatile on record. For example, if you bought a portfolio of corporate bonds at the end of World War II, by the end of 2008 you would've lost your entire cumulated excess returns, only to recoup them again in 2009. That volatility won't return and it's mathematically impossible to beat the kind of returns we had in 2009.
Going forward it is best to focus on the most interesting parts of the markets. We view financial institutions, the high-yield markets and the lessons learnt from Dubai last year, as the main points of interest for 2010. Out of these, the macro trends are favouring banks.
Credit markets are peculiar because in every downturn there is one part of the market that does exceptionally worse than everything else; causing the downturn. In the early 1990s the problem sector was banking; in 2002/2003 it was technology, media and telecommunications; and this time again it has been the banks.
The problem sector will emerge from recession the cheapest and chances are will do a complete turnaround coming out of a downturn. That's what happened to banks in the early 1990s and TMT in 2003 and that's what is expected for banking this time round.
Almost all the initiatives coming from regulators (US, Asia or Basel III) are generally negative for growth in the banking sector, yet positive for bond holders. They create less risk, less risk-taking and higher capitalised institutions with stickier funding. They also create more boring, yet safer asset portfolios. This is a credit-friendly trend and one thing we're certainly telling investors to focus on.
What structure can we expect banks to use for their bond issues?
This will be a really strange year for financials because they will be raising capital in one part of the market and they will be redeeming capital in others. So it can be tricky to know what's going on.
The best way to make sense of this is by coming back to this regulatory trend. We had a downturn where banks went into the recession with fairly elaborate capital structures that ranged from senior debt at the top to subordinated hybrid debt below, and then common equity at the bottom. The recession proved that the bank capital mechanisms didn't work -- junior hybrid debt didn't absorb the losses that they were supposed to and banks became extremely reluctant to issue tier-2 debt.
These lines of defence that were built up over the years by regulators and banks folded under the pressure. As a result, the global regulatory environment became disillusioned with the loss-absorbing performance of sovereign capital. Regulators are now telling banks to get rid of the structure and no longer rely on hybrid tier-1 or tier-2 debt. The message is to build up reliance on core tier-1 and senior funding.
The middle part of the capital structure will shrink with more reliance on the top (senior debt) and the bottom (equity). When you see where the issuance is coming from banks globally, it is equity. There were a lot of financials raising equity last year, which has continued into 2010.
Asian economies are underleveraged compared to more mature economies. As a function of economic growth, we will see a gradual maturing of household use of leverage. Banks are growing their balance sheets faster and that's going to require capital. Banks will look to increase senior and lower tier-2 debt capacity and equity.
Going forward, banks need funding either through raising equity or raising senior debt. There is significant uncertainty over the future landscape of the capital structure and investors, issuers and arrangers alike won't know [what it will look like] until the Basel III documentation has been received at the end of this year.
What is the impact on the region from the liquidity tightening in China?
This is an unusual cycle because for the first time Asian central banks are leading the tightening coming out of the downturn and equity markets clearly don't like it. Historically, this is a situation that has led to near-term volatility. [But] as markets get used to the idea that it's tightening for a good reason, it won't change the underlying trends in either asset markets or volatility. The credit spreads will continue to decline and equity volatility will continue to decline as well. It fits very well with historical patterns, where spikes in volatility accompany no change in trend.
What it also does is put the spotlight on the parts of the markets that are most sensitive to policy tightening. Given the unusual amount of credit expansion in China in the past 12 months it draws attention to the bond market side.
Typically this is a period when reserve rate requirements are tightened. This is a bad period for the property market because [developers] are exposed to lending conditions from their own access to credit and their customers. As a result they underperform. The way we have positioned it in our model portfolio and what we're telling investors is that this is not the best time to build up exposure towards property bonds.
However you have to maintain perspective. Loan growth will come down from Rmb9.5 trillion ($1.39 trillion) towards Rmb7.5 trillion, but that is still 20% of Chinese GDP. This is equal to accumulated totals from 2004 to 2006, which was the period when no one was worried about the lack of loan growth. This is not a situation where liquidity vanishes from China but the trend is a major headwind for property bond issuers.
What can we expect from India?
India had a significant credit expansion prior to this downturn, and therefore in many people's views was exposed through the recession. But the policy makers have approached the situation very proactively and what we have coming out of this, is a set of banks which have performed quite well. But they're raising capital partly for expansion purposes. Because of government ownership limitations, many of the state-owned banks face constraints as to how much equity they can raise in the markets without diluting the government stakes. Therefore, they are in some ways forced towards the bond markets and that's one reason why there are so many state-owned banks issuing paper this year.
Can a comparison be made between Indian and Korean bank issuers?
The situations are quite different. Indian banks have a much deeper domestic pocket to tap into. In other words, loan-to-deposit ratios are much lower than they are in Korea.
Korean banks have historically relied much more actively on wholesale markets and global bond markets than Indian banks. Due to the upward pressure on the Korean won, Korean regulators want to see the reliance on overseas wholesale funding markets reduced.
That's one of the reasons why some analysts favour Korean banks -- the regulators are pushing the banks to take less risk with their funding structures. What can be expected from Korea are less reliance on short-dated overseas funding and more reliance on deposits, equity and longer duration periods.
What is Asia's exposure to the sovereign credit risk from the emerging European markets?
Credit spreads in [emerging] Europe are on par with Asian spreads. The widest trading sovereigns are trading wider than the widest trading Asian spreads.
We have a completely unique situation on our hands. What it ultimately means is that someone will have to pay for fiscal deficits and increasing sovereign debt. There are really only two ways to do it -- raise taxes or cut spending. Both have a negative impact on economic growth and are negative to corporate profitability as well as corporate credit traps.
There is partly an explicit crowding out effect when governments raise a lot of capital. There is a negative impact from remaining in a Keynesian expansionary fiscal position that will have a negative spill-over effect on gross and net corporate earnings.
Ultimately, we don't think the corporate and sovereign markets are independent of each other. But it is very clear and interesting that rating trends are diverging, with the rating trends in Europe being negative while in Asia they are positive.
How would you rate Asian regulators' response to the financial crisis?
Asian governments have been fairly proactive with the way they have approached their funding throughout this downturn. Firstly, they have proactively raised capital in anticipation of future needs, which means they are far less exposed to volatility in comparison to other regions.
Secondly, they have also ventured into a new wave of securing liquidity in periods of stress. For instance, the Koreans, Chinese and Japanese have been working together to secure and share foreign reserves between governments. This is also a way of diversifying funding sources and reducing exposure to any shortage in liquidity globally, even if that is triggered by an event in Europe.
The verdict when looking back on this is that regional policy makers have been proactive about managing risk. Asia has learnt from experiencing a similar crisis only 10 years ago.
Do you have final comments?
The overall macro backdrop for credit markets will not see a repeat of 2009. It's mathematically impossible. Where last year was a once-in-a-lifetime opportunity for credit, this is perhaps a once-in a-decade opportunity. The public is missing the fact that credit spreads are historically wide.
A sub-par economic recovery in the US is not a bad environment for credit. Morgan Stanley calls it BBB, which stands for below par, bumpy and boring -- not bad for credit.
Usually financials are the most interesting part of the global credit market, particularly for Asia. This could be a multi-year story, which is not obviously equity friendly but definitely very credit friendly. There are signs that the US is easing lending conditions for borrowers as well, which is a positive.
The overall backdrop is a fairly favourable one, but the ride could be a bumpy one and we're obviously seeing that right now.