Fixed Income

Investment Grade (IG) Credits

Hunt for yield remains intact

In contrast to sovereign bonds, we prefer credits given our higher return expectations for the latter. Our view for a gradual global growth recovery and accommodative monetary and fiscal policies should underpin credit spread compression and we still see value in credits as a means of income generation. Amongst the credit segments, we favour Asia Investment Grade (IG) and High Yield (HY) bonds for their relatively more resilient fundamentals and attractive valuations.

Developed Markets IG (Neutral)

We have a neutral stance on Developed Markets (DM) IG credits as we believe the bonds offer a balanced risk-reward profile. In 2021, DM economies including the U.S. are expected to recover from a sharp recession following the easing of lockdown restrictions. Policymakers’ ongoing commitment to providing more stimulus will also help businesses and jobs. Meanwhile, major central banks remain committed to monetary easing, including asset purchases that will lend support to demand for DM IG credits. In particular, the Fed and ECB corporate bond purchases provide a highly supportive backstop for the asset class.

Since the pandemic recession, many IG corporates have acted conservatively by building cash balances and extending debt maturity profiles. Despite the modest rise in net leverage, IG corporates continue to maintain a high credit quality with an average credit rating of A-. Hence, we believe DM IG credits are well-positioned to navigate the potential renewal of economic headwinds, if any. Further improvements in corporate earnings should help to reduce leverage, thus improving overall credit quality.

Valuation-wise, DM IG credits (which are largely represented by U.S. IG credits) are trading at 104 basis points as at end-November, below the 5-year historical average of 128 basis points, suggesting limited scope for a strong outperformance. Moreover, the duration of U.S. IG credits has been extended, suggesting a higher sensitivity to interest rates. We expect a modest rise in U.S. Treasury yields in 2021 and this could offset any potential compression in credit spreads, thereby moderating the returns for DM IG credits. In addition, the supply of U.S. IG credits was substantially higher in 2020 than in 2019, and could remain elevated in 2021. This could potentially lead to some imbalances in supply-demand that could weigh on overall price returns, thus capping the performance of the asset class.

PREFERRED SECTORS

Asia Quasi-Sovereign Bonds

We prefer corporates over financials as the latter will likely suffer from the aftershocks of the COVID-19 in the coming months. Within IG corporates, we see value in select quasi-sovereign bonds given sovereign linkage, decent standalone profiles and robust Asian investor demand.

China Financial Bonds

While we are cautious on financials as a whole, Chinese banks stand to benefit from higher rates. We like subordinated Additional Tier 1 (AT1) bonds with short calls from strong Chinese banks and non-bank financials with strong parentage in Greater China.

Emerging Markets IG (Neutral)

Reasonable yields and diversification benefits

While we expect a gradual recovery in economic activity, the elevated number of new COVID-19 cases in several major Emerging Markets (EM) economies is a key downside risk. Notably, these countries tend to have weaker healthcare infrastructure and potentially limited access to vaccination. In addition, some EM economies are heavily reliant on commodities or tourism, which make them more vulnerable in the current economic environment.

That said, EM corporates have undertaken prudent corporate behaviour before the pandemic outbreak and EM IG credits generally have more financial buffers to weather the economic downturn than their HY counterparts. However, valuations for EM IG credits are slightly expensive relative to history, offering 150 basis points versus 5-year historical average of 173 basis points (as of 30 November 2020).

Given the balanced risk-reward, we prefer to adopt a neutral stance on EM IG credits with a preference for Asia IG as we are less concerned over Asia’s economic fundamentals.

Asia IG (Overweight)

We hold a constructive view on Asia IG credits with an overweight stance on the asset class. Asia IG credits boast robust credit quality with an average credit rating of A-, similar to U.S. IG bonds.

The resilience of the asset class is further demonstrated by the fact that it has only witnessed fallen angels to the tune of 1.4% of the entire Asia IG universe in 2020, which is only slightly higher than the 1.2% average for the past 10 years. In addition, Asia IG credits offer attractive yield pick up of 52 basis points over and above U.S. IG credits (as of 30 November 2020).

Furthermore, Asia IG’s high exposure to China (at around 50%) provides room for spread compression as it is furthest along in the economic recovery following the Chinese government’s effective control of COVID-19. In fact, China’s growth recovery is expected to accelerate in 2021 and we expect a broadening of growth into other sectors as Chinese policymakers shift their priorities to ensure financial stability. On this front, a gradual reduction of stimulus may signify policymakers’ growing confidence in the recovery and underpins our positive stance on the region.

In view of the above, investors should look to add exposure to Asia IG credits in their portfolios, given the defensive characteristics, relatively low volatility, and strong domestic buyer base especially when the economic recovery is expected to be uneven across other EM countries and sectors.

Undoubtedly, the ongoing U.S.-China tensions remain a key downside risk for Asia IG credits as more China state-owned enterprises (SOEs) and technology names are being put on the U.S. government’s entity list. However, the impact to fundamentals should be manageable given lesser reliance on the U.S. for revenues or funding access. Less hostile and more predictable U.S.-China relations should help to improve market sentiment towards Asian assets, including Asia IG credits.

Sharp rise in duration for U.S. IG bonds in 2020

Source: Bloomberg I November 2020

EM IG bond performance will be driven by credit selection

Source: Bloomberg I November 2020

Asia IG bonds offer attractive yield pick up over U.S. peers

Source: Bloomberg I November 2020

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