Diamond Capital Management (Switzerland) Ltd.

Asia HY Market update

Asia HY Market update

The Asia high yield market continued to rally this week, as broker dealers continued to see aggressive buying from global real money accounts, as investors are starting to become constructive on the Asian high yield market for the second half of 2018.

The two macro factors that previously drove a strong rally in the offshore USD Chinese corporate bond market in the second half of 2015 were (1) CNH/RMB depreciating against the USD (this drives Chinese investor demand for offshore USD bonds, as they start favouring USD denominated investments), and (2) onshore liquidity easing in China (which is currently being driven by the recent policy measures implemented by the Chinese government, see below) - and we are starting to see this combination of macro factors emerging again.

The yield premium offered by Asian HY debt over similar notes worldwide has surged in 2018, reaching the highest level since 2014 this month. Investors in the bonds are becoming more comfortable as they’re getting paid for uncertainty that’s been partly driven by the trade tension. Among the asset class, Chinese property bonds offer good opportunities.

Chinese Monetary Policy:

Risk sentiment for Asian credit improved significantly over the past 2 weeks as China embarked on a multi-pronged approach to provide monetary easing and infrastructure investment from the government.

Partially as a response to the ongoing trade tensions with the US, China policymakers have ramped up policy easing measures in recent weeks. Measures introduced include the Chairman of the China Banking and Insurance Regulatory Commission (CBRC) requesting commercial banks to increase loan supply to private companies and small & medium-size enterprises (SMEs).

China’s State Council announced measures to stabilize domestic demand on 23 July 2018, including:

  • A more active fiscal policy, focusing on two areas:
    • (i) implementing tax and fee reductions, including an overall tax & fee burden reduction of 1.1 trillion yuan this year, tax rebates for advanced manufacturing and modern service sector, and expansion of R&D deductible policy from small & medium-size tech firms (previously) to all corporates (newly implemented);
    • (ii) accelerate local government bond issuance to support ongoing infrastructure investment projects.
  • Monetary policy will ensure ample liquidity and reasonable financing growth, and encourage lending to small & medium-size enterprises (SMEs). The government will increase state guarantee support for SMEs.
  • Clean up zombie companies to ensure efficient use of credit, crack down illegal financial institutions, and continue to implement initiatives to reduce systemic financial risk.

In recent months, banking system liquidity has remained abundant. The People's Bank of China (PBOC) reduced banks’ RRR (required reserve ratio) by 25bps in April 2018, and further reduced the RRR by another 25bps in June 2018, for a total of 50bps cut to the RRR. These measures have helped lower China’s onshore interest rates.

The above measures have made it clear that economic and market stability has become the near-term priority for China, which is a move in the right direction. Given the focus by policymakers, and expectations of more policy loosening to come, systemic risk within China will continue to be low and well managed.

As a side note, China’s Q2 2018 GDP growth came in at 6.7% yoy, which is a very healthy figure.

One of the drivers of the weakness in the Asia high yield market over the past few months has been concerns about a potential credit crunch in China due to the ongoing deleveraging initiative implemented by the government, which negatively impacted sentiment amongst China onshore investors. However, the recent easing measures has helped to stabilize China’s onshore corporate bond market sentiment.

Having said that, note that China’s recent easing measure have been very targeted, in the sense that the directives have been aimed at providing credit and funding to sectors and institutions that require it, but still maintaining the focus of deleveraging the overall financial system within China and continuing to clean up zombie companies in over-capacity industries.

We have held the view that the availability and amount of financial resources at the disposal of China has never been in doubt, partially due to the country’s massive USD 3 trillion plus FX reserves and its large monthly trade surplus. The main uncertainty from investors in the past has been whether China’s government will be able to implement the right steps to deleverage its financial system while still maintaining a healthy GDP growth rate. With the recent actions, we think China has responded well to both its domestic and geopolitical challenges.

Separately, a note on the China property sector:

The number of unsold homes in China continued to drop in June 2018, the latest sign that a national campaign to rebalance the property market is effective. The unsold housing stock in 100 Chinese cities declined 8% from a year ago to 426.43 million square meters at the end of June, according to a report by E-house China R&D Institute, a property research agency. That figure retreated to the level of more than six years ago (the decline in housing inventory started in 2015 when the country decided to tackle a home-building frenzy).

The China property sector remains one of the most systemically important industries to the Chinese government, due to its interlinkage with banks’ balance sheets, consumer mortgages, and household net worth. As such, it is a sector that will continue to be well managed by the Chinese government through the availability of mortgages, mortgage financing rate, and policy measures to prevent any potential overheating within the sector. We believe that the China property sector will continue to be stable, and hold the view that exposure to the large Chinese property developers provide an attractive risk adjusted return, due to the good carry from the coupons, and good downside protection (due to its systemic importance to the Chinese government, and strong underlying asset coverage).