Asia credit outlook: Asia and EM credit technical to undergo key reversal

It is easy to appreciate the ongoing grab for yield globally. We strongly believe this will only intensify as 2024 unfolds. 
 

Need to know We now expect Asia/EM to swing from net outflows over 2022-2023 to net inflow in 2024  Overall, we expect new issuance in Asia to only pick-up as the Fed cuts rates We believe that October 2023 marked the start of a new multi-year cycle of strong total returns with lowered volatility for global fixed income

 

Technical trend

Developed market (DM) credit spreads by risk measure (downgrade and default risk) is still cheap from a theoretical perspective, but very tight from a historical range perspective. For example, US investment grade (IG) credit spreads which move within 80 to 160 bps through cycles, is already currently at 100 bps. Still, we expect the path of least resistance to be tighter for DM spreads owing to the ‘weight’ of money that will fall on credit bonds in the coming quarters as Fed rates are cut and capital starts to reverse from money market products back into duration based fixed income spread products. 

This technical trend will benefit Asia and EM, which offer higher spread across IG and high yield (HY) (adjusted for duration and ratings). The beta spread compression for Asia/EM will further intensify as USD hedging cost versus Asian currencies reduce as the differential between US rates and Asian domestic rates once again increase as the Fed cuts more than Asian central banks. This will lead to more domestic Asian capital search for USD spread products in the region.
 

Key reversals in market technical 2023 versus 2024E¹

The Asia credit universe has seen an unprecedented shake-out since 2021 with USD 124 bn of cumulative defaults since 2021 from the China property sector. However, Asia ex-China has remained muted with the average high yield (HY) default rates over the last decade at only 1.6% p.a., displaying the resilience of many HY companies ex-China property across the region. 

Additionally, the asset class has suffered from US Treasury sell-off, large outflows across Asia-EM credit funds. 

We now expect Asia/EM to swing from net outflows over 2022-2023 to net inflow in 2024. 
 

FIG. 1 ASIA/EM OUTLOOK 
 

Source: LOIM. For illustrative purposes only. Past performance is not a guarantee of future results.
 

Lower Asia net supply to provide support for credit spreads

From a supply perspective, Asia USD net issuance has been negative for the last two years. Gross supply of USD Asia ex-Japan ex-Australia bonds were at USD 110 billion versus the historical averages of over USD 200 billion. This lack of supply is driven by cheaper onshore refinancing channels, deleveraging of corporate balance sheets, increasing early tenders and secondary market purchases by issuers. 

Overall, we expect new issuance in Asia to only pick-up as the Fed cuts rates, increasing the attractiveness of USD funding relatively to local onshore refinancing channels. However, we expect net issuance to be negative, providing for a strong market technical in 2024 compared with 2023.
 

FIG. 2 ASIA-EM ISSUANCE TO INCREASE BUT NET ISSUANCE WILL BE NEGATIVE 

Asia issuance forecast. Source: J.P. Morgan, Bond Radar, Bloomberg Finance. As at 30 November 2023. Key credit themes in Asia. For illustrative purposes only.
 

Attractive relative value in Asia versus US credit

In terms of valuations, the Asia IG (ex-quasi-sovereigns) universe offers material spread pickup relative to US IG (using JULI index) on a duration adjusted basis of 116 bps, and at a higher average credit rating of A- for the JACI IG versus A-/BBB+ for US IG. This is despite around 40% of the index in very low-yielding sovereigns, quasi-sovereigns, and China banks and leasing papers that trade tighter than US IG. While these segments have outperformed over the last few years, they offer little to no spread compression potential into a Fed cutting cycle. Excluding these segments can provide investors with stronger total returns over a long-term horizon.
 

FIG. 3 ASIA IG SPREADS REMAIN WIDE TO US IG CREDIT AND AT HIGHER AVERAGE CREDIT RATINGS 

*Normalised for 6 year duration, using linear scale Sources: Asia IG spread pick-up. Source: Bloomberg, JP Morgan, Lombard Odier. As at January 2024. Spreads above are not duration adjusted except where highlighted. US IG uses JULI index.
 

Within HY, the universe offers attractive opportunities across India, Indonesia, Macau, Southeast Asia and across special situations which benefits from secular growth in the region. On an index level, the JACI HY ex-China property trades at attractive spreads of 686 bps compared to US HY at only 428 bps (i.e., a significant spread pick-up of 258 bps).
 

Our sector preferences for 2024 and structural dislikes India renewables

The India renewables space remains our top sector pick, supported by its strong growth outlook as the country set an ambitious target of 50GW of annual renewable energy capacity addition for the next five years. The capacity addition target is meant to help India achieve its ambition of having 500GW of cumulative installed capacity from non-fossil fuel sources by 2030. We believe that the country’s commitment towards clean energy will present multi-year opportunities for investors to participate in India’s renewable growth story. To realise this goal, we expect the government to continue their supportive stance towards the sector and onshore funding access to remain favorable for the sector. 

To encourage the healthy growth of the renewable sector, the government had introduced the Late Payment Surcharge (LPS) scheme to resolve the receivables situation from state-owned distribution companies (discoms) back in June 2022. Under LPS, the government allowed discoms to repay their past dues in various installments ranging from one to four year and the discoms could be barred from short-term power exchange market if they do not meet their current obligations on time. These measures had proven to be a great success with the receivables situation in the sector improving significantly since its implementation. Prior to LPS, the outstanding receivables stood at INR 1.2 trillion (USD 15 billion) and are now down by 40% to INR 700 billion (USD 8.3 billion). This has in turn improved the cashflows across the renewable energy companies.

Looking ahead, we believe this trend to continue into 2024 which should result in improving credit fundamentals for the sector. 

In addition, we expect the sector to enjoy cheaper funding access via onshore market. Domestic lenders, especially government owned non-bank financial companies (NBFC) i.e., REC and Power Finance Corporation (PFC) had significantly stepped up their funding for renewable projects and we continue to expect them to play a pivotal role in providing support for the sector. 

In terms of valuation, we find the sector attractive at 7.5-9.5% yield given its robust industry outlook and potential alpha opportunities. The India renewable sector also offers decent pickup over US BB-rated High Yield names which are trading at 6.5% yield with a longer duration.

FIG. 4 STRONG GROWTH VISIBILITY FROM INDIA GOVT TARGETS OF 50 GW P.A. FOR NEXT FIVE YEAR PERIOD FROM 2023 TO 2028
 

Source: India govt targets of 50 GW p.a. Source: Bloomberg NEF Research, Ministry of New and Renewable Energy. For illustrative purposes only.

FIG. 5 SIGNIFICANT IMPROVEMENTS IN RECEIVABLE COLLECTIONS ACROSS MAJOR RENEWABLE COMPANIES

Source: company filings, BofA Global Research. For illustrative purposes only. Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.
 

Indonesia quasi-sovereign 

We expect Indonesia’s macroeconomic backdrop to remain robust despite its GDP growth moderating to 5.0% in 2024. Whilst its capital spending is expected to slow ahead of the presidential election, other macro conditions remain supportive for the country’s fundamental. We expect Indonesia to remain disciplined in its fiscal balance with low debt burden. As such, its sovereign metrics is likely to remain strong. Inflationary pressure is likely to remain benign in Indonesia with CPI coming in at the lower end of Bank Indonesia (BI) range. This should allow BI flexibility to ease if needed. Likewise, UST yield is likely to have peaked and that should ensure that Indonesia rupiah (IDR) remains stable in the coming year. 

We see little value in Indonesia sovereign bonds given the rich valuation with the credit spreads trading at sub-100 level. To express our constructive view on Indonesia, we see the best value in Indonesia quasi-sovereign given its attractive spread pick-up over the sovereign. Given their government ownership and ratings tied to the sovereign ratings, we think the Indonesia quasi-sovereigns still offer value with its 80-100 bps spread pickup over the sovereign. It also offers attractive opportunities for us to add duration via the Indonesia quasi-sovereign long-end curve. 

Within the Indonesia quasi-sovereign universe, our top pick is Freeport Indonesia. We like Freeport Indonesia given its robust credit fundamentals and operational scale. We continue to see positive credit drivers with the potential extension of mining concession benefiting the long-end bonds the most and the completion of smelters strengthening its value chain integration. Likewise, the Indonesia government is looking to increase its stake in the mining company. This means that the Freeport Indonesia curve is likely to compress towards the sovereign curve.

FIG. 6 INDONESIA QUASI-SOVS OFFER ATTRACTIVE SPREAD PICKUP OVER THE SOVEREIGN
 

Source: Bloomberg as at 19 December 2023.
 

Macau gaming 

Macau gaming remains as one of our top picks as the sector will continue to benefit from the impact of China reopening and improving consumption demand in 2024. The continued improvement in profitability and cash flows will drive proactive deleveraging in the next 12 to 24 months, leading to stronger credit profiles and positive rating actions. 

We have seen the continued recovery in visitation from mainland China in 2023, despite the weakness within the domestic Chinese economy. Visitations peaked during the Golden Week period this year with an average visitation of 88,634 per day, which represents a recovery of 84% versus pre-COVID levels. Visitations into Macau have remained strong in November and December, which will translate into an overall 70-75% recovery as compared to 2019 levels. Visitations from mainland China will continue to improve as group tours regain traction which will capture more visitors from inland Chinese tourists. Additionally, the trend of longer stays from 1.9 days to 3-4 days will likely continue as a structural change, thus increasing consumption and gaming revenues for the operators. The recovery in mainland visitations has translated into an improving Gross Gaming Revenue (GGR) for the gaming sector, which has recovered to ~70% of 2019 levels in the first 11 months of 2023. Mass market recovery is even stronger at ~87% in the same period, driven by the regulatory change and strategy shift of the gaming operators towards this market. Mass market gaming revenues will likely exceed 2019 in the next 12 to 24 months as evidenced by the 106% recovery in October 2023, while overall gaming revenues will return to 2019 levels. Overall, we are still seeing strong positive momentum in terms of revenue recovery from these factors.

FIG. 7  IMPROVING GAMING REVENUE FROM INCREASING VISITATIONS
 

Source: DICJ, JPM Research. For illustrative purposes only. Past performance is not a guarantee of future results.

The recovery in gaming revenues, especially in the mass market segment, have substantially improved operating profits and cash flow generation this year. The margins generated from the mass market segment have historically been stronger as compared to the VIP segment, which can offset some potential inflationary pressure. Capital expenditure commitment required as part of the 10-year license renewal is smaller as compared to the previous license requirement. On top of that, operating expenditures from events can be calculated as part of this requirement. Thus, capital expenditure needs will be limited driving more positive free cash flows. On the back of this, we have seen issuers proactively repay their debt, such as MGM and Wynn Macau with the revolvers, and Studio City prepaying the USD bonds through a tender process.3 We expect to see more proactive debt repayment in 2024 as cash flows continue to improve and issuers look to optimise their capital structures. Such actions have led rating agencies to provide positive rating actions on several of these issuers and we expect this trend to continue in 2024 and 2025 as leverage profiles continue to improve.
In terms of valuation, we find the high yield issuers still attractive at 7-9% yield levels due to the room for further tightening as credit profile improves. Proactive debt management might lead to further upside potential from bond buybacks or bond tender process. Sands China bonds still remain attractive with more than 100bps z-spread premium over its US parent, Las Vegas Sands.

FIG. 8 IMPROVING CREDIT PROFILE THROUGH PROACTIVE DELEVERAGING
 

Source: Company financials, LOIM estimates.

FIG. 9 ASIA-EM KEY FAVOURED SECTORS 

FIG. 10 ASIA-EM STRUCTURAL UNDER-ALLOCATION 

 

Strong total returns in global fixed income with an additional boost from Asia credit

After a confluence of negative left-tail events owing to Covid-19, Russia-Ukraine war, China property crackdown together with a sharp Fed hiking cycle, we believe that October 2023 marked the start of a new multi-year cycle of strong total returns with lowered volatility for global fixed income. 

Within Asia credit, the risk-reward is extremely asymmetric now given the supportive global macroeconomic backdrop, along with supportive fundamentals and technicals across the region that should allow investors to achieve strong three-year total returns from high carry and all-in-yield compression.

In the table below, we attempt to illustrate the potential returns from a portfolio of Asia high grade (average) bonds with 6-year duration and credit spread of 250 bps. We calculate this by using a US Treasury 7-year and a proxy BBB benchmark, eight-year bond with a credit spread of around 250 bps. 

Consequently, we find the respective total returns for different US Treasury and IG spread assumptions over the next one to three years. Our base case for total returns by 2026 is highlighted in green below.

FIG. 11  TOTAL RETURNS FOR DIFFERENT US TREASURY AND IG SPREAD ASSUMPTIONS

Sources: Assumptions: Use T 4 3/8 11/30/30 Govt as UST proxy and BBB proxy bond with 2031 maturity - to arrive at 6 year duration. Asia IG return projections. Source: Bloomberg, Lombard Odier. As at 9 January 2024. The model above is for illustrative purposes only and does not purport to be a recommendation of an investment in, or a comprehensive statement of all of the factors or considerations which may be relevant to an investment in, the referenced securities. For illustrative purposes only.

In a theoretical bear case scenario where US inflation stays high and prompts another round of Fed hikes, where US Treasury yields go to 6% and investment grade (IG) spreads widen by 50 bps, investors would still generate positive returns of 11.2% over the next three years owing to high carry. 

On the flip side, if US Treasury yields stay at 4% or compresses towards 3% coupled with some spread compression, the total returns could be in the range of 22% to 27% respectively over the next three years.
The main point is that it is arguably more difficult for investors to lose money in fixed income (not just Asia but globally) from here onwards, while the risk-reward is skewed to the upside owing to (1) high carry and (2) potential to see meaningful all-in-yield compression over the coming years. Note that this exercise is purely mathematical and reflects potential returns for a pure-IG, 6-year duration portfolio with all-in-yields of 6.5% currently. 

For a blended portfolio with long duration IG balanced with quality short-dated HY, this would allow stronger three-year cumulative returns in a comfortable range of ~20-40% (USD).

 

1 Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document

For professional investor use only

This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the “FCA”), and entered on the FCA register with registration number 515393.
Lombard Odier Investment Managers (“LOIM”) is a trade name.
This document is provided for information purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This material does not contain personalized recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipient exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. This material contains the opinions of LOIM, as at the date of issue.
Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term "United States Person" shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.
Source of the figures: Unless otherwise stated, figures are prepared by LOIM.
Although certain information has been obtained from public sources believed to be reliable, without independent verification, we cannot guarantee its accuracy or the completeness of all information available from public sources.
Views and opinions expressed are for informational purposes only and do not constitute a recommendation by LOIM to buy, sell or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change. They should not be construed as investment advice.
No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient, without Lombard Odier Asset Management (Europe) Limited prior consent. In the United Kingdom, this material is a marketing material and has been approved by Lombard Odier Asset Management (Europe) Limited  which is authorized and regulated by the FCA.

© 2024 Lombard Odier IM. All rights reserved.