Here’s why the smart money is rotating to Chinese credits

Asean wins the nod of Asian G3 investors largely because of Indonesia. But six months since Asset Benchmark Research (ABR) pitched the question of where to be to achieve the best risk-adjusted return, the smart money is starting to rotate into China credits.

In October 2016, ABR asked a panel of investors to rank which credits would provide the most reasonable risk-adjusted return over the coming 12 months. Out of the total, 36% of respondents ranked Asean at the top; three in ten opted for China; roughly one-quarter picked India and only 2%, Korea.

Part of Indonesia’s attraction is because of the sell-off in 2016 that hit emerging markets as an asset class. “If we go back a year or so, the sectors or the regions that have been harder hit were potentially some of the emerging market (EM) or oil-related names,” explains Bryan Collins, portfolio manager at Fidelity International. “Certainly, some of the longer duration assets were a little bit more impacted as well. It was very much part of a commodity slowdown.” Indonesia was out of favour and to some extent so was India.

He explains that the oil recovery as well as the economic recovery in the latter part of 2016 helped to drive returns in credits such as Indonesian sovereign and quasi-sovereign names. “A lot of these instruments were slightly longer duration or have more spread duration so they rallied harder in total return terms because they were at such depressed levels to start with. We got a lot of capital uplift thanks to some of the longer duration assets,” Collins says.

However, Indonesian credits are now moving out of favour. “Interest rates have already come down and inflation is going to go up to about 5%,” says Wilfred Wee, a portfolio manager at Investec Asset Management. “Indonesia is still a current account deficit country so as global liquidity tightens the authorities are going to have to respond. In other words, it’s still very foreign capital dependent. And domestic politics are less supportive this year.”

Volatility is a greater issue and even though the Fed rate hike cycle is largely priced in, there could still be moves with duration playing a larger role. “When you look to Indonesia and to some extent India, generally speaking you have relatively high-quality but also longer-dated instruments. I suspect they’ll be a little bit more volatile.”

Instead the focus is going to shift to China. “I would choose between China and Asean,” relates Wee. “China manages its currency as a basket as well as Asean as a whole. The rest will be a bit idiosyncratic and to be fair I don’t think that there are any strong stories.”

Collins shares the same view: “Where I think the real value would be is from a risk-adjusted or volatility-adjusted perspective where some of the names within the China complex, which is huge and getting bigger, are probably going to be the sweet spot for low volatility, reasonably attractive, single digit total returns.”

Methodology

The Asian G3 Bond Benchmark Review, now in its sixteenth year, was conducted in the third quarter of 2016. A total of 352 Asian G3 bond investors including asset managers, hedge funds, private banks, insurance funds and commercial banks from Hong Kong, Singapore, the rest of Asia, UK/Europe and the US took part.

Data sets include market penetration, market share/wallet share, buying criteria/client satisfaction, research content and the top individuals. Follow-up interviews are conducted with a selection of respondents in each market to provide qualitative data. To learn more about the Asian G3 Bond Benchmark Review please click here.

Additional reporting by Jacky Fung