Please upgrade your browser

We take your security very seriously. In order to protect you and our systems, we are making changes to all HSBC websites that means some of the oldest web browser versions will no longer be able to access these sites. Generally, the latest versions of a browser (like Edge, Chrome, Safari, etc.) and an operating system family (like Microsoft Windows, MacOS) have the most up-to-date security features.

If you are seeing this message, we have detected that you are using an older, unsupported browser.

See how to update your browser

Asia high yield bonds: where do we go from here?

In this article, Geoffrey Lunt, Senior Investment Specialist, Fixed Income, discusses the lessons learned from the China real estate crisis and how the Asia high yield bond market has changed as a result.
18 May 2022
    Download the full reportPDF, 2.68MB

    Key takeaways

    • The poor performance of Asia High Yield over the last year was almost entirely confined to the China real estate sector and was not a more generalised issue relating to Chinese or Asian credit
    • Excellent historical performance and misreading of government policy led to overinvestment in China real estate bonds
    • We can learn from this episode that China policy makers are determined to inject moral hazard into financial markets in the medium term, while we need to remain ever vigilant to the governance of investee companies
    • Over the last year, the China real estate sector has shrunk dramatically as a proportion of the Asia high yield market, resulting in a more balanced and diversified overall investment. We may look forward to more opportunities in India, Indonesia and bonds which aid the transition of Asia to a lower carbon economy
    • The policy rhetoric in China has become increasingly supportive, with strong acknowledgement that the negative consequence of tight COVID restrictions will need to be offset by looser monetary and fiscal policies
    • Generally speaking, fundamentals of Asian companies are decent with likely modest default rates outside China real estate
    • The higher carry and lower duration of the Asia high yield market, together with the prospects of a modest recovery in China real estate, suggest decent absolute returns and potential outperformance versus other fixed income asset classes
    • Active duration and credit beta management, and most importantly selecting the right bonds, could potentially add substantial value in a market offering valuations which can be inconsistent with fundamentals

    Source: Bloomberg, HSBC Asset Management, May 2022.

    The information contained in this publication is not intended as investment advice or recommendation. Non contractual document. This commentary provides a high level overview of the recent economic environment, and is for information purposes only. It is a marketing communication and does not constitute investment advice or a recommendation to any reader of this content to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management accepts no liability for any failure to meet such forecast, projection or target.

    What were the drivers of the negative returns?

    It’s probably not too dramatic to say that the Asia high yield market has been in complete chaos over the last year as the financial model of Chinese real estate developers first came into question, and then fell into a state of collapse. This would have been a significant situation if it had occurred in any large sector of the market, but the China real estate sector comprised around 37 per cent of the universe in May 2021, making the impact devastating to the overall market, which since that point has experienced losses of around 22 per cent. To put any analysis into context, it’s important to acknowledge that this was a problem which was largely confined to the China real estate sector and was not a more generalised issue relating to Chinese or Asian credit.

    If we are first trying to learn lessons from what happened, then, our analysis needs to be focused on the China high yield real estate sector.

    Fig. 1: Asia high yield 1-year performance

    1-year total return (per cent) as of 28 April 2022

    Fig. 1: Asia high yield 1-year performance

    Source: Bloomberg, Markit, BofA, JPMorgan, as of April 2022.

    Why did it happen?

    Excellent historical performance and misreading of government policy led to overinvestment in China real estate bonds

    On the most basic level, the introduction of a round of policies to promote financial stability in the China real estate sector and to reinforce the tenet that houses are built to be inhabited, not for speculation, was the key catalyst for the crisis. The property market was always driven by regulation, but this tightening cycle was notable for both its duration and scope, in particular the ‘three red lines’ policy which mandated deleverage.

    But this in itself doesn’t really answer the questions as to why a single sector had such a dominating presence in the market and therefore why its collapse had such a devastating influence, or why the collapse was so complete.

    It is of course easy to be wise with hindsight, but we need to be completely transparent and honest if we are to learn the painful lessons from this episode. The China real estate offshore debt market was almost certainly unsustainable on a standalone basis. As we quite quickly saw, once the weaker developers were denied funding because of the refusal of offshore borrowers to roll over their debt, their demise was almost immediate – they were often just one bond issue away from disaster. In retrospect, on some level there must have been an expectation that the sector would get extraordinary support from local or national government due to its strategic importance to the Chinese economy. It is perhaps still something of a surprise that greater support has not been provided to the sector given what we now know about the overall condition of the Chinese economy.

    On top of this, the history and performance of the sector may have contributed to overinvestment. China real estate bonds actually provided excellent historical returns over many years, while the business model was somewhat intuitive (borrow-build-sell-borrow-build-sell etc), especially in an economy which had experienced explosive growth in residential real estate, soaring prices and ongoing urbanization.

    Fig. 2: High yield market performance over the last 10 years vs. over the last year

    10-year period, 31 May 2011=100

    Fig. 2: High yield market performance over the last 10 years vs. over the last year

    1-year period, 31 May 2021=100

    Fig. 2: High yield market performance over the last 10 years vs. over the last year

    Source: Bloomberg, Markit, BofA, as of April 2022. Asia indices are using iBoxx USD Asia ex Japan; US high yield index is using ICE BofA US High Yield Index.

    The negative consequences of overinvestment were those which are familiar to any seasoned bond investor. In many cases, covenants had become increasingly weak (often non-existent) and bond structures ‘innovative’ in a way not favourable to the noteholder. But the more devastating impact, also symptomatic of such episodes, was the revelation that some developers had not been fully transparent about the extent of their borrowings, while others had simply given misleading steers to investors either through incompetence or dishonesty. This had a huge knock on effect to confidence in the sector as investors began to doubt even the strongest investment grade and state owned companies in the sector – an impact we are seeing to this day.

    What can we learn from this episode?

    China policy makers are determined to inject moral hazard into financial markets in the medium term and can be surprisingly steadfast, while we need to remain ever vigilant to the governance of investee companies

    The evolution of China’s financial markets and their integration into the global system continues. Whatever obstacles in terms of geopolitics and speed of policy implementation, we remain convinced that the direction continues to be clear and enduring. We were fully aware that there were likely to be bumps along the road, but as investors collectively, we may have assumed that the China authorities would have intervened more forcefully to iron out some of those bumps.

    We might therefore dare to assert that contrary to the conventional narrative – that the handling of the real estate funding crisis was dogmatic – the Chinese authorities were, in fact, allowing the free markets to resolve the situation in a somewhat brutal fashion. This may have the consequence of injecting more moral hazard into the thinking of both issuers and investors, leading to a more transparent and fairer capital market.

    Meanwhile, the importance of detailed examination of the governance of companies in all sectors and across developing markets is brought into sharp relief by this crisis. The competence and motivations of the main shareholders – in these cases often one person or a small group – and their attitude to creditors, have been important determinants of the outcome in a number of instances.

    Despite some lurid headlines, we have not found as a rule that offshore bondholders have been particularly badly treated compared to other creditors. It is important to consider the structural subordination of offshore bondholders, which is by no means unique to China, but we do not feel unfairly treated, while differences in outcomes can come down to dumb luck – for instance whether onshore or offshore liabilities become due first.

    Where do we stand now?

    The composition of the Asia high yield universe has changed profoundly, resulting in a more balanced and diversified overall investment

    As we look forward to what the future holds for this asset class whether in the short or the long term, we may take comfort from the fact that the China real estate sector has shrunk dramatically as a proportion of the overall market. Although we might expect some outperformance from this sector over the next few quarters (as discussed below), nevertheless it will not perform to the extent that it will materially reflate the weighting. Meanwhile, the now proven-to-be-flawed business model of the highly leveraged China real estate company and the skepticism which now greets the prospect of investment in their bonds, imply strongly that the sector will never be so dominant again, and indeed could shrink further. So while it is likely to remain the focus of attention while it is creating most of the volatility – and possibly opportunity – in the Asia high yield universe, over time it should potentially become increasingly less important and dominant in the assessment of the asset class as a whole.

    This also increases the weighting of interesting companies and sectors from other parts of Asia. Because of their low sovereign ceilings, much of the issuance from India, Indonesia and Philippines is high yield and, with the capital markets in these countries growing strongly, we may look forward to an array of opportunities. We should also definitely not forget the role of the bond markets in the transition of Asia to a lower carbon future. India renewable energy has already become an important sector and we expect this to grow further, while it is not difficult to see the same happening in other countries, especially Indonesia with its huge population and future energy demands.

    Fig. 3: Evolution of Asia high yield sector/geography composition

    As proportion of JACI non-investment grade index

    Fig. 3: Evolution of Asia high yield sector/geography composition

    Source: JP Morgan, HSBC Asset Management, March 2022. Sector breakdown uses HSBC’s internal sector classification. For illustrative purposes only.

    What is the fundamental outlook for Asia High Yield?

    As is usually the case, the macro outlook varies across the region. But generally speaking, fundamentals of Asian companies are decent with likely modest default rates outside China real estate. The policy environment for China real estate, meanwhile, is improving, while bond prices already discount something close to a worst case scenario

    The global backdrop has been toxic for fixed income over the first four months of 2022, with high inflation, geopolitical tension and increasingly hawkish central banks proving a highly challenging cocktail. In Asia, the weakness of the Chinese economy, exacerbated by the headwind of stringent COVID policies, has led to doubts as to whether the authorities’ target of 5.5 per cent GDP growth for 2022 can be met. Meanwhile, other countries in Asia are facing the same inflation concerns as so much of the rest of the world, which can be particularly egregious for emerging economies which have less scope for discretionary spending.

    There may be room for optimism at this juncture, however. The macro narrative is not necessarily indicative of market direction, especially in fixed income markets, while a lot of this bad news is surely now discounted. With 75bp of US interest rate rises already implemented and around 200bp implied by interest rate futures, there may be limited further upside to global bond yields. The policy rhetoric in China, in contrast, has become increasingly supportive, with strong acknowledgement that the negative consequence of tight COVID restrictions will need to be offset by looser monetary and fiscal policies, with no small degree of emphasis on the housing market. We are seeing a drip feed of policy on both the local and national level which should soon begin to have a beneficial effect – although more will need to be done and the transmission between policy implementation and real economic impact will not be instantaneous.

    Fig. 4: Asia high yield cash / total debt

    Asia high yield corporates cash to total debt

    Fig. 4: Asia high yield cash / total debt

    Source: JPMorgan as of April 2022.

    And there is further cause for cautious encouragement when we look closer at the fundamentals of the Asia high yield universe. Outside China (which is so heavily skewed by real estate), companies have manageable leverage and ample liquidity, meaning that we are expecting a default rate under 3 per cent of market value in 2022. When we include China and real estate, the actual credit loss forecasts are also low, given that so much of the market has already discounted a very poor outcome.

    What are the prospects for returns?

    A lot will depend on the global environment and the extent to which interest rate rises and inflation dynamics continue to roil risk markets. But the higher carry and lower duration of the market, together with the prospects of a modest recovery in China real estate, suggests outperformance of other fixed income asset classes

    Stating the obvious, global markets are highly volatile at the moment, making forecasting particularly difficult. Unfortunately, forecasting returns for the Asia high yield market is even more difficult for a couple of reasons. First, default expectations and forecasts are not that useful when a lot of the riskiest part of the market is already trading at levels discounting a high probability of- or actual- default. Second, calculations of yield are not designed to accommodate short bonds trading at distressed levels – this skews average yields to meaningless levels which do not reflect the likelihood of total return. We have seen some preposterous forecasts for returns based on the literal yield calculations which we would urge investors to treat with caution.

    Therefore, to model returns in a meaningful way, it is probably best to forecast the real estate and non-real estate sectors separately. We have also taken the approach of splitting China real estate down further into those bonds trading under 40 (which have on average a high likelihood of default or restructure), those trading between 40 and 70 (with a medium probability of default or restructure) and those trading over 70 (on average having a reasonable probability of repaying at par).

    Figure 5 shows the statistics of the four components of the market (JACI non-investment grade corporate) when the yield of any bond trading below 40 cents in the dollar is excluded, and under 70 given a haircut of 50 per cent. The conservative approach with bonds trading under 40 is partly predicated on the experience of the restructurings which have already taken place. There is low confidence among investors that these moves, on average, will change the long term viability of the relevant issuers.

    Fig. 5: Scenario analysis excluding the yield of bonds trading below 40 and applying 50 per cent haircut to bonds below 70

    Fig. 5: Scenario analysis excluding the yield of bonds trading below 40 and applying 50% haircut to bonds below 70

    *Note for interest: without this adjustment, the technical yield calculation would add 4.66 per cent to overall yield of the market with an average yield for this component of 117.2 per cent!
    Source: HSBC Asset Management, Bloomberg, JPMorgan 5 May 2022. Hypothetical analysis is for information purpose only and should not be relied on as indication for future result.

    It is important to note, of course, that this makes significant generalizations about the prospects for each component – it does not mean, for instance, that we expect all of the bonds over 70 to pay back at par nor that everything under 40 will never pay another coupon. But once we have this framework, which approximates what we believe is close to the average state of play for each of the segments, we can then run scenario analysis which may give us some forecasts for total returns. For the sake of scenarios below (Figure 6), we have assumed a 0 per cent default rate for China real estate, given the already distressed condition of the market and the capital adjustment accounted for as a separate item.

    Not surprisingly, with unchanged yields, the market should deliver something in line with the yield indicated in Figure 5.

    Fig. 6: Scenario 1 – where yields remain unchanged and healthy China real estate continues pull to par and paying coupons; under 70 remains at same price

    Fig. 6: Scenario 1 – where yields remain unchanged and healthy China real estate continues pull to par and paying coupons; under 70 remains at same price

    Source: HSBC Asset Management, Bloomberg, JPMorgan, 5 May 2022. Hypothetical analysis is for information purpose only and should not be relied on as indication for future result.

    A reasonably optimistic scenario might result in modestly tighter spreads across the board, no significant change in levels of US Treasuries over the year and some price performance from the distressed developers, demonstrated in Figure 7.

    Figure 7: Scenario 2 – where yields fall 50bp; healthy China real estate continues pull to par and paying coupons; under 70 experiences uplift 5-10 points

    Figure 7: Scenario 2 – where yields fall 50bp; healthy China real estate continues pull to par and paying coupons; under 70 experiences uplift 5-10 points

    Source: HSBC Asset Management, Bloomberg, JPMorgan 5 May 2022. Hypothetical analysis is for information purpose only and should not be relied on as indication for future result.

    A less favourable scenario (Figure 8), which includes yield rises of 100bp and some further deterioration in the distressed China real estate sector still gives decently positive returns (our asymmetric skew to the downside for these three scenarios is based on the current trend upwards in yields and widening of spreads).

    Fig. 8: Scenario 3 – where yields rise 100bp; healthy China real estate continues pull to par and paying coupons; under 70 experiences deterioration of 5-10 points

    Fig. 8: Scenario 3 – where yields rise 100bp; healthy China real estate continues pull to par and paying coupons; under 70 experiences deterioration of 5-10 points

    Source: HSBC Asset Management, Bloomberg, JPMorgan 5 May 2022. Hypothetical analysis is for information purpose only and should not be relied on as indication for future result.

    Of course, there is an infinite number of scenarios we could employ, many far more optimistic or pessimistic than those shown, but we think that these represent a reasonable confidence of the range of outcomes. Our own central forecast would probably be for an average of these three (around 8.5 per cent), which indicates a slight skew to the downside of the ‘unchanged yields’ as we remain concerned about the global inflationary outlook which has the potential to linger now that expectations may have become unanchored. This may result in higher US treasury yields and wider spreads globally.

    The reader may be surprised to see the quite narrow range of scenario returns, which we do not believe is entirely down to our rather undramatic forecasts. It also betrays three important features of the Asia high yield market as we move into the future which investors should keep in mind. First, it remains a very low duration market, meaning that changes in yields have a potentially muted impact on total returns. Second, the China real estate market now makes up such a smaller proportion overall that its volatility will likely have less of an effect in the future. Third, the high yields now available give a good cushion of carry which make meaningfully positive returns potentially possible even with rising yields. We may hope for more boring times ahead.

    It is perhaps fair to assert, then, that on the balance of probabilities, Asia high yield has a good chance of potentially outperforming other fixed income asset classes in the coming quarters. The higher yield gives a good cushion, while the lower duration is advantageous in a rising interest rate environment. In order for other asset classes to outperform, it is likely that treasury yields would have to begin to fall significantly, which may be unlikely at this juncture with the global inflation outlook so uncertain.

    Conclusion

    Although the market has fundamentally changed during this period of chaos, we are cautiously optimistic for the near and long term future of Asia high yield

    Extreme volatility and drawdowns perhaps always provide us with valuable lessons, and we might look back now on the China real estate funding crisis as an important step in the evolution in the integration and development of Chinese capital markets. The global economic conjuncture adds further complication to an assessment of the future prospects for Asia high yield and is particularly problematic for bond markets when inflation and interest rates are so much in focus. But when we look at the fundamentals of the market and also the characteristics of the securities within it, we may gain a degree of confidence that the Asia high yield market can potentially provide both decent absolute and relative returns in the coming year. Importantly, we look not just to China for opportunities, with India and Indonesia and the transition to a lower carbon economy exciting drivers of future returns.

    Returns can also be potentially enhanced by effective active management. Off benchmark positioning in Asia local currencies and investment grade bonds, as well as duration and credit beta management, can likely further improve diversification and returns. Importantly, selecting the right bonds from a bottom up perspective could add substantial value in a market still perhaps offering some valuations which are inconsistent with risks and fundamentals.

    Investment involves risks. Past performance is not indicative of future performance. Any forecast, projection or target contained in this presentation is for information purposes only and is not guaranteed in any way. HSBC Asset Management accepts no liability for any failure to meet such forecasts, projections or targets. The views expressed above were held at the time of preparation are subject to change without notice. The information provided does not constitute any investment recommendation in the above mentioned sectors, asset classes, indices or currencies. For illustrative purposes only.

    Do you find this useful?
    Star - 1 out of 5 Star - 2 out of 5 Star - 3 out of 5 Star - 4 out of 5 Star - 5 out of 5

     


    Getting started
     

    Learn more about HSBC funds

    Find out how to invest

    Individual investors

    Fund center

    Contact us

    Financial intermediaries

    Fund center

    Contact us

    Institutional investors

    Contact us

    Want to stay connected with us?

    Subscribe to our newsletter now


    Important information

    The value of investments and the income from them can go down as well as up and investors may not get back the amount originally invested. Past performance contained in this document is not a reliable indicator of future performance whilst any forecasts, projections and simulations contained herein should not be relied upon as an indication of future results. Where overseas investments are held the rate of currency exchange may cause the value of such investments to go down as well as up. Investments in emerging markets are by their nature higher risk and potentially more volatile than those inherent in some established markets. Economies in Emerging Markets generally are heavily dependent upon international trade and, accordingly, have been and may continue to be affected adversely by trade barriers, exchange controls, managed adjustments in relative currency values and other protectionist measures imposed or negotiated by the countries with which they trade. These economies also have been and may continue to be affected adversely by economic conditions in the countries in which they trade. Mutual fund investments are subject to market risks, read all scheme related documents carefully.

    The contents of this document may not be reproduced or further distributed to any person or entity, whether in whole or in part, for any purpose. All non-authorised reproduction or use of this document will be the responsibility of the user and may lead to legal proceedings. The material contained in this document is for general information purposes only and does not constitute advice or a recommendation to buy or sell investments. Some of the statements contained in this document may be considered forward looking statements which provide current expectations or forecasts of future events. Such forward looking statements are not guarantees of future performance or events and involve risks and uncertainties. Actual results may differ materially from those described in such forward-looking statements as a result of various factors. We do not undertake any obligation to update the forward-looking statements contained herein, or to update the reasons why actual results could differ from those projected in the forward-looking statements. This document has no contractual value and is not by any means intended as a solicitation, nor a recommendation for the purchase or sale of any financial instrument in any jurisdiction in which such an offer is not lawful. The views and opinions expressed herein are those of HSBC Global Asset Management Global Investment Strategy Unit at the time of preparation, and are subject to change at any time. These views may not necessarily indicate current portfolios' composition. Individual portfolios managed by HSBC Global Asset Management primarily reflect individual clients' objectives, risk preferences, time horizon, and market liquidity.

    We accept no responsibility for the accuracy and/or completeness of any third party information obtained from sources we believe to be reliable but which have not been independently verified.

    Copyright © HSBC Global Asset Management (Hong Kong) Limited 2022. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, on any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of HSBC Global Asset Management (Hong Kong) Limited.

    This document has not been reviewed by the Securities and Futures Commission.

    HSBC Global Asset Management is the brand name for the asset management business of HSBC Group. The above communication is distributed in Hong Kong by HSBC Global Asset Management (Hong Kong) Limited.