A short duration ride on Asia’s robust credit wave

The start of vaccine rollouts late last year triggered optimism about a rebound in economies. Yet recovery is clearly uneven, in turn breeding a range of risks from high debt levels impacting access to funding, to likely rises in interest rates and inflation, to a slower pace of growth globally.

Within fixed income, this has created an investment dilemma. Three immediate questions jump to mind for any investor:

  • How do I generate desired returns in a zero rate environment? 
  • How do I prepare for an increasingly volatile and uncertain macro outlook?
  • How do I hedge against rising rates, which seem inevitable in the US along with many other markets?

Achieving these goals requires an approach that is well-suited for a world of scarce yield, looming policy tightening and elusive growth momentum.

Downside mitigation, diversification and carry are all options to address a specific investment need. Within these, short duration Asian bonds offer a potentially compelling answer to the current predicament for fixed income investors.

A three-pronged solution

The priorities for a short duration Asian bonds portfolio should include country and sector diversification while applying credit discipline, removing the temptation to chase yield.

Against today’s investment backdrop, these objectives enable such a portfolio to address concerns over yield, uncertainty and hedging.

There are two ways to tackle the yield issue. First, investors can migrate down the yield curve by extending duration – although this is risky in a rising rate environment. Secondly, they can migrate down the credit curve, for example moving from government bonds to credit, or from developed to emerging markets (EM).

Within the EM universe, Asia continues to lure capital flows due to historically more attractive yields, good macro fundamentals and favourable credit characteristics. Investing in this high-yielding region, therefore, can deliver the much-needed yield pick-up to investors.

When it comes to managing an unpredictable – and risky – market environment, a flexible and resilient strategy is needed, which would potentially suffer less during drawdowns without sacrificing much of the upside during the rally.

A short duration bonds portfolio typically has lower volatility and relatively high liquidity during stressed periods. This is a result of having a larger percentage of an overall portfolio in bonds that mature regularly and, therefore, offer potential for regular cashflow that could alleviate the need for forced selling.

To buffer against rising rates, meanwhile, a short duration bonds portfolio systematically reallocates the risk budget from interest rate risk to credit risk – a risk more manageable with active and robust credit analysis.

Put simply, this creates less sensitivity to rate and credit spread movements compared with debt that has a longer duration.

Given that rates and bond prices typically move in opposite directions, an environment of rising rates is challenging for long duration bonds, which might face significant losses. At the same time, the price of bonds nearer maturity tends to be closer to par than longer duration bonds, due to an ability to estimate coupon and capital payments with greater certainty.

Key features of an effective short duration portfolio

A short duration Asian bond portfolio with specific characteristics may offer investors the potential for outperformance:

  • Flexible allocation to offer exposure to investment grade and high yield bonds, enabling discretion to position for both risk-on and risk-off environments
  • Duration of less than 3 years to guard against rising rates – and potentially enabling cashflows from maturing bonds to be reinvested at higher rates in the market
  • A focused exposure in China with important diversification into other emerging markets  to capitalise on the region’s growth trajectory
  • Being ESG integrated into the investment decision-making to filter out major ESG risks

Capitalising on Asia’s credit credentials

A short duration approach that can tap into the Asian credit story is particularly appealing for investor portfolios amid the wider market landscape.

Ultimately, there is persistent relative value in the region, especially in fixed income.

For example, Asia is populated by high-growth economies coupled with rapidly expanding and diversifying debt issuance. The region also has a favourable credit risk profile; the Asian hard currency credit market is more highly rated than its global counterparts and rating trends are positively skewed.

Higher yields are apparent, too. For instance, Asian credits have historically offered a meaningful spread premium over their global peers, which allows potential yield enhancement for similar credit risk. This has been seen in terms of Asian credit providing a yield pick-up versus global credit for an equivalent credit rating, and with lower volatility.

The role of China is also too big to ignore. As the world’s second-largest fixed income market at around US$17 trillion[1], the market’s growth has a long way to develop further, fuelled by the ongoing boost from bond index inclusion in accelerating integration into global markets.

Notably, high nominal government bond yields, significant relative value in credit spreads and diversification benefits of RMB exposure in hard currency portfolios can enhance performance.

Further, China’s bond markets include offshore USD and CNH issues, which often offer higher yields compared with onshore counterparts. This creates a potential additional alpha source for the right credit research.

Selectivity is the key to making the most of these opportunities, not just in China, but also across Asia, given the diversity in the region’s dynamic and ever-evolving markets. But being active is just the starting point; investors must also seek yield while staying focused on managing a changing environment in rates and inflation.

[1] Source: AXA IM. *Data as of Q3 2020