Liquidity freed up by near 0% interest rates in the developed markets has rushed into Asian US dollar denominated investment grade (IG) debt, pushing yields to record lows. But the spread over US Treasuries remain high, a trend that will likely grow more marked this year. There was a 450% increase in foreign investment into Asian US dollar-denominated debt in the first half of this year compared to the same period last year. According to EPFR, US$3.7 billion flowed into the region, pushing yields to record lows. Average investment grade yields in Asia are around 3.4%, according to Bloomberg data.
But spreads over Treasuries remain wide. The current spread is 277.8 basis points (bp), which is around the same level as in late 2009. Five-year treasuries are yielding 0.63%. As such, despite historically low yields in Asian credit, from a carry perspective it remains very attractive.
According to Viktor Hjort, credit strategist at Morgan Stanley, historically the spread has made up around 20% to 30% of the total yield. Today, that number is around two-thirds for US IG credit and in around 70% for Asian US dollar IG credit.
"So the more you think that sub-par economic growth or central bankers choosing to maintain rates low will continue for an unusual amount of time, the more appealing Asian credit will look from a pure carry perspective," he said to Asiamoney PLUS.
He believes that the significance of carry to the valuation of Asian IG credit will only increase from here and he is therefore constructive on Asian credit even if spreads do not tighten materially.
"That’s for Asia credit as a whole, particularly in investment grade. It is less the case in high yield because spread tightening has been very significant and that’s very much a factor of China rallying this year on the back of improving credit in China and a strong performance from the property sector," he said.
Corporate bond yields in Asia are likely to continue to be dominated by the credit spread, agrees John Woods, chief Asian strategist at Citi Private Bank.
"Currently, Asian bonds are very much a technically driven story driven by flows. Essentially, when the ECB [European Central Bank] dropped the rates it paid on deposits to 0% it unleashed a tidal wave of liquidity which pushed down yields to record lows. Unless or until the eurozone problem is resolved, we’re going to continue seeing this liquidity dynamic driving returns," he said.
However, while he believes there will be some tightening, he argues that yields are unlikely to fall far below their current levels. This is for three reasons. Firstly, investor sentiment in Asia remains relatively positive, and the region’s equity market has not been given the cold shoulder as it has in the west.
Secondly, growth in Asia is robust and Asian central banks remain wary of inflation, meaning that rates are unlikely to be cut substantially. Thirdly, Asia’s local currency bond market is growing at such a fast pace that it is highly unlikely foreign inflows will overwhelm it.
"There’s going to be increasing appetite by issuers, because European banks are scaling back their presence in Asia and the ability of corporates to access lending is diminishing. For that reason we’re seeing a lot more interest in the issuance of debt as an alternative funding option," he said.
But relative value plays an important role, as average IG yields in Asia are around 3.4% with an average duration of slightly under five years. Comparable high grade corporate debt in the US has a longer average duration of around seven years, and a lower average yield of around 2.9%, according to Woods.
"The relative value of Asian risk versus US risk remains attractive so I think yields will just grind in tighter over the course of the year," he said.
And as carry comprises 70% of the yield, even a slight tightening will have a more marked effect than in the past.
"I think the bull case for credit sits somewhere here. The more you think that yield expectations can be anchored by central bankers, or investors who are giving up on anything other than sub par growth, the more appealing the carry that is being offered by credit should look in the eyes of fixed income investors," said Hjort.
According to Woods, the only risk to this outlook will be found in the spread. If some sort of disorderly event develops in the eurozone, such as an ill-managed ‘Grexit’, the probable result will be a marked widening in spreads.
"But in our view, between now and the end of the year the likelihood of a disorderly exit is low. The ECB is kicking the can down the road and I think if there is going to be a day of reckoning it’s going to be next year instead of this year," he said.