Diamond Capital Management (Switzerland) Ltd.

China Sell-off and Impact on Asia HY

The selloff in the China and Hong Kong equity markets over the past few days, driven by Chinese government policy actions on the education and technology sectors (in addition to the recent campaign to cut leverage in the property industry), weighed on investor sentiment and led to a substantial selloff in the Asian fixed income market.
The Chinese government is tightening regulation on certain sectors due to different reasons. For the internet/technology sectors, it’s related to (1) the government’s concern about sharing domestic data with foreign sources, (2) to clamp down on monopolistic behaviour, and (3) to adjust regulation in a sector that has media/social media presence. For the education sector, it’s to revamp the education industry in China as the government feels that the private tutoring sector is widening the social divide between the rich and the poor. While for the property sector, it’s to drive a deleveraging in the sector at the expense of rapid growth (which is a positive for credit and generally a negative for equities). As it pertains to fixed income, both the internet/technology and education sectors are predominately investment grade (IG) issuers, not high yield (HY) issuers, therefore the impact on the USD denominated debt market will be felt mainly in IG, and not HY.
The recent selloff in Asian high yield is mainly attributable to investor sentiment rather than any broad deterioration in fundamentals or macro data. In the past, when the Asian high yield market has sold off due to investor sentiment rather than a change in fundamentals, the market has historically rebounded back strongly once sentiment normalizes, so we expect the same to happen this time around. Valuations, particularly in the high yield property sector, has reached very cheap levels only seen a few times over the past decade (and each time the rebound has been strong when sentiment normalizes), as such, we see this as a buying opportunity – particularly when the government policy driving the selloff in the property sector is actually a long-term positive for credit as it is meant to speed up deleveraging and reduce tail risk.
In addition, given that Asian high yield has been underperforming this year within fixed income globally, we expect a mean reversion in performance for the asset class (particularly when fundamentals remain sound), and result in an outperformance vs. global fixed income in the near future. The case for mean reversion in Asian high yield is made more convincing when we compare the default and recovery rates in Asian high yield vs. US high yield, with Asian high yield having an average default rate of 1.9% over the past 16 years, compared to 2.8% for US high yield (in fact the outperformance of Asian high yield is even more pronounced over the past 5 years with an average default rate of 1.94% compared to the 3.48% for US high yield). While the average recovery rate on default over the past 12 years (includes the GFC period in 2009-2010) in Asian high yield is 45.6%, superior to the 39.4% of US high yield.