Q&A: Barings puts cash back to work

Baring's head of Asian debt investment explains why market dislocation is providing investment opportunities.
Sean Chang
Sean Chang

The first two months of the year have been incredibly challenging for financial markets, with investors worried that central banks are running out of ammunition to stimulate global growth.

So far, the Asian domestic and G3 currency bond markets appear to have weathered the volatility fairly well.

The region’s largely buy-and-hold investor base has continued to underpin primary and secondary market prices even though issuance levels are down overall and credit spreads are wider.

Many borrowers have also still been able to come to market and take advantage of ultra low US Treasury yields to lock in low absolute cost of funds.

Over the coming month, FinanceAsia will run a series of Q&As with some of the region’s leading fixed income fund managers, ascertaining their views on the impact the uncertain market backdrop is having on their trading strategies.  

First up is Dr Sean Chang, head of Asian debt investment at Baring Asset Management in Hong Kong, a position he has held since 2012. Chang and his team oversee the firm's Dublin-registered China bond fund, which was launched in 2011, plus retail and institutional debt portfolios. 

Chang is also taking part in a panel discussion at FinanceAsia's 7th Annual Borrowers & Investors Forum, which takes place at the Ritz-Carlton Hotel in Hong Kong today (March 2).

The Asian team also supports Barings’ 30-strong global fixed income team, providing research and investment advice for the firm’s emerging market and high yield bond funds. Assets under management across all the fixed income funds total $9.1 billion.

While Chang is a pan-Asian specialist, his particular strength is China, which has put him in a strong position as the country’s onshore bond market develops and its offshore issuers increasingly dominate the G3 league tables. At the turn of the decade he gained his first experience in the domestic market when he ran its first QFII fund at Hang Seng Bank.

How have you responded to the market turbulence over the first couple of months?

Sean Chang: We’ve definitely been more conservative and raised our cash holdings. At the peak, we held up to 8% in cash but it’s coming back down now to about 4% again and we intend to feed the rest out over the coming months.

What’s your big picture view of the market’s behaviour?

We actually think it’s been a bit dislocated over the past six months because of strong FX movements. But we’re now at an interesting juncture and that’s throwing up opportunities.

Specifically, the US dollar has been very strong but we no longer think this is a one-way street. We’ve already started to see this scenario play itself out in January. Some regional currencies that sold off last year such as the renminbi and Indonesian rupiah, for example, have strengthened recently.

What’s driving this?

I think you need to look at the interest rate differential between Asia and the US. Rates are a lot higher in this region and that yield differential is very supportive of the region’s currencies and bonds at a time when Asian central banks are cutting rates to try and stimulate growth.

They still have the room to cut rates and maintain a high yield differential to the US, which is attractive to investors. It’s a very different story in the US, Europe and Japan where central banks are now having to rely on negative interest rates.

Will the Fed raise rates again this year?

Policy wise that appears to be Janet Yellen’s agenda, but the financial markets clearly believe the opposite will be the case. US Treasury yields have been falling not rising. The 10-year is now down to around the 1.7% level when most forecasters were predicting it to be well above 2% by now.

How are you adjusting your strategy to fit this new reality?

We’re opting for longer duration bonds and particularly like China. The onshore sovereign yield curve is very flat. There’s only 2.5bp of steepening per annum between two and 10-year paper, or roughly 30bp across the curve.

If central banks can continue providing more stimulus and maintain stability, then the long-end will outperform in China and across the rest of Asia as a whole.

Are you worried the domestic market may be in a bubble thanks to the large numbers of investors who switched out of equities into bonds last year? They could just as easily move on again.

To be fair, liquid bond markets are a global phenomenon thanks to the quantitative easing and bond buy-backs we’ve seen in Europe and the US. China, on the other hand, is a slightly different kettle of fish. Banks there are still earning a net interest margin that's higher than 2% compared to Europe, where they’re contending with negative interest rates.

I’m very positive about the onshore bond market. China has cut rates six times since November 2014. But it’s also developed a whole range of other liquidity enhancing tools, which will support the market. It’s now conducting daily OMO (open market operations) to inject cash into the banking system and through SLO’s (short-term liquidity operations), MLF (medium-term lending facility) and PSL (pledge supplementary lending) etc.

How are you playing the onshore market?

Actually what’s interesting is the relative value between the domestic and offshore market. According to the HSBC China Local Currency Government Bond Index, the onshore market provided a return of 8% during 2015. By contrast the HSBC Offshore RMB Bond Index was down 2.4% on Rmb offshore terms.

Theoretically there shouldn’t be that big a gap since they are the same country, same currency. 

But how correlated are those two indices? The first tracks government bonds, while most dim sum bonds are issued by companies.

Actually about 30% of the offshore index comprises government bonds. Of the remaining 70%, about 70% of that are investment grade corporates and only 30% pure high-yield. 

The offshore market also has quite a large pool of outstandings these days. Growth has been quite remarkable really. From zero in 2011, the pool is about $90 billion these days. 

So what explains the difference between onshore and offshore performance?

Most of it comes down to concerns about a weakening of the Rmb, so offshore investors have been less keen to hold Rmb-denominated assets. But offshore investors have also shown themselves to be far more focused on headline risk than onshore investors, and less sensitive to any government easing moves.  As the Rmb stabilises I think this situation could reverse itself quite quickly.

There was a lot of turbulence in the currency last August after the PBoC adopted a new methodology for fixing the currency on August 11. But the reality is that it only dropped about 4% last year and 2% this year before rebounding 1%.

I think the PBoC is taking a less interventionist approach where the currency is concerned. It used about $108 billion of reserves in December, but $99 billion in January so the figure has been on a downward trend even though it is still high.

It’s also prevented offshore institutions from speculating with their Rmb by implementing reserve requirement ratios on the offshore market. These seem to have been effective and the currency is now back to its 2014 level. 

What about domestic corporate leverage? Is there a danger Chinese companies are being a bit too enthusiastic about loading up on Rmb-denominated debt now the issuance process is much easier and rates are so low?

Well as long as they repay or re-finance the bonds at maturity then it won’t be a problem!

I think it’s much better that real estate companies, for instance, no longer have to rely on the foreign currency debt market. History has shown over and over again that countries and companies, which get themselves into repayment difficulties, do so because they’ve borrowed too much from overseas markets.

If Chinese real estate companies can rely on the domestic market for funding and re-financing far more, then it will create a buffer for them. Leverage can be good or bad depending on what the money is being used for. I think we’re actually seeing a lot of de-leveraging in China.

You mean the local government financing vehicles? How successfully do you think the government has been able to de-risk municipal balance sheets?

I think it’s a bit too early to say. But things are definitely moving in the right direction. It’s good to see the government encouraging the SOE’s to reduce their spending and focus on restructuring.

Isn’t it difficult trying to cherry pick good companies onshore because local investors don’t do much credit work?

Onshore investors are definitely on a learning curve and it will take time. But the three international credit rating agencies have onshore tie-ups so it’s only a matter of time before domestic investors start applying the same criteria as international investors.

But this is how we fund managers can generate alpha. Inefficient markets generate opportunities for sophisticated investors.

Can you give an example?

Well the property sector is very interesting and again it comes down to onshore/offshore relative value opportunities. There’s generally a 200bp to 300bp differential between the two.

Those credits with more headline risk attached to them can be up to 400bp wider in the offshore market. Probably 100bp of that is due to subordination within a company’s capital structure, but the remaining 300bp is pure risk premium.

Look at Agile, for example. Its onshore bonds are yielding about 4.7% while its offshore bonds are yielding more like 9%. If a fund manager knows a company well and believes its fundamentals are solid that kind of differential is a good one to play.

But doesn’t Agile highlight idiosyncratic risk? In China a company’s financials can look ok, but if the chairman or CEO is suddenly taken for questioning the bonds will trade down dramatically. It must be almost impossible to manage that kind of political risk because it’s unquantifiable.

It is hard to manage and idiosyncratic risk has obviously spiked enormously over the past 24 months. But it’s still possible to navigate if you know the company well and are in regular contact. We look for very simple things such as changes in body language, or the unexplained absence of a key official.

Our analysts are also interacting with these companies every month either at conferences or making visits. That’s the big advantage of being based in the region.

We’re not just reliant on just the financial and credit fundamentals to make our investment decisions.  You really need to know these companies inside out.

What’s your view on Chinese bank capital paper? It’s trading at very tight levels compared to global comps. Is this sustainable given the downward spread movement in Europe and the US? Will investors be tempted to start taking profits?

I think secondary spreads will be stable, but whether Chinese banks can raise new money in large size at those levels is another matter. This kind of paper is very popular with Chinese investors.

But Chinese banks are also very different beasts compared to global peers. They're still quite straightforward deposit taking and lending institutions. They don’t have all the associated risks from derivatives.

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