The specialist Asian investment house describes how it has been positioning to handle market volatility and what sort of opportunities it sees emerging in the region's fixed income market.

One of the larger Asia-based asset management houses, Eastspring Investments ($125 billion of client money), is, like many of its peers, working out how best it can position itself at a time of uncertainty around China’s economy. There are concerns about just how fragile China’s still-young financial system is, as the country continues to switch towards being more of a service-based economy. This publication recently interviewed David Lai, who is an investment director at the firm’s fixed income team and based in Singapore. Lai is an emerging markets specialist but his role requires him to examine a whole range of markets.

Since the market sell-offs in January, how has Eastspring changed, if at all, its asset allocations on Chinese assets in broad terms (equities, bonds, cash, alternatives, other)?

From our fixed income team’s perspective, we view that the market rout in January was a result of a sharp retrenchment in investor sentiment globally but the macroeconomic headwinds behind this shift in sentiment, however, were not entirely new; sustained declines in oil prices, as well as concerns over growth in China and uncertainty surrounding the direction of the renminbi, are headwinds that have been playing out over the past year. More importantly, we view that there are mitigating factors which should help China avoid a hard landing scenario and which are often overlooked by the market. Firstly, we do not expect a collapse in external demand with the US and eurozone recovery appearing intact.

Domestically, China’s services sector, which accounts for around half of the country’s GDP, remains resilient, while retail sales continue to grow at a double-digit pace on a year-on-year basis. Additionally, the closely-managed nature of its economy and the relatively sound economic fundamentals (e.g. strong FX reserves, high level of savings, adequately capitalised banks) continue to provide room for manoeuvre by policymakers to stabilise markets or to boost growth, where needed.

Given this view, we have not made significant adjustments to our overall allocation to the China US dollar credit market following the market sell-off in January. It is also worth noting that in spite of the volatile external environment this year, performance of Chinese dollar credits has been relatively resilient with an overall positive gain on a year-to-date basis.

What is Eastspring's position on mainland China/Hong Kong-based debt and credit in terms of weightings, tactical views?
Our positions in Chinese debt or credits are held mainly in our regional Asian credit funds. For our flagship Asian Bond Fund, which invests predominantly in dollar-denominated bonds, our exposure to Chinese credits is around 38 per cent (as at end February 2016), which translates to a slight underweight position relative to the benchmark weight. 
     
While we hold a relatively sanguine view on the Chinese economy, we recognise that credit cycle has turned more negative due to the slowing economy and excess capacity build-up in a number of industries. In such environment, idiosyncratic risks are likely to rise and credit differentiation will be increasingly important as performance across the Chinese credit market could be more uneven going forth. As such, our portfolio positions in Chinese credits are driven more by our bottom-up views rather than top-down sectoral/country views. For example, while we maintain our view that oil prices are likely to remain weak, we continue to hold overweight positions in selected Chinese oil and gas names which benefit from strong government support (due to the companies’ strategic importance) and which have significant downstream operations where the higher profit margins provide some buffer to the weakness in upstream activities.  

Moreover, although we maintain an overall overweight in the Chinese property sector in line with our stable outlook on the property sector, we are more cautious of adding high yield property names at current valuations. The more cautious stance in the Chinese high yield property sector is premised on our view that valuations are less attractive, thereby providing less risk buffer during bouts of risk aversion.

When is the last time the firm changed its asset allocations significantly?

Our positions are managed dynamically and may be adjusted as and when our investment views change, be it on a top-down or bottom-up level. For example, for our flagship Asian Bond Fund, we increased the cash balance to a relatively high level of around 10 per cent in the middle of last year as we viewed valuations to be less attractive and that the macroeconomic headwinds then could lead to bouts of risk aversion. 
 
What is the firm's view of negative real interest rates in Japan and the impact this could have on currencies such as the renminbi, or other?

We view that the unconventional monetary policy decision underlines the central bank’s resolve to do whatever it takes to keep deflationary pressures at bay. However, the efficacy of such measure remains debatable, as corroborated by the market reaction which saw yen appreciating significantly following the policy announcement. There is also limited room for Bank of Japan to press on further on this monetary policy route without risking the stability of financial institutions in the longer term.

Nevertheless, if the ECB’s experience is a guide, the negative interest rate environment in Japan could stay for a while. This could drive a search for yields as banks are forced to lend or invest rather than keep cash in deposits. While the quantum and pace of such portfolio flows are hard to predict, we expect a gradual increase in funds flowing out of Japan to markets with solid fundamentals and decent yields, and ex-Japan Asia is hence expected to be one of the beneficiaries.
  

Please elaborate on your views about the reason for holding emerging Asia bonds as opposed to other emerging market debt? Do you favour local currency bonds or dollar-denominated debt and if so, why? 

We have seen Asian US dollar-denominated bonds outperforming the broad emerging market due to their defensive qualities over the past year. In 2015, the Asian US dollar bond market rose by 2.8 per cent, while emerging market and US corporates returned 1.1 per cent and -1.4 per cent respectively. 

We expect some of the factors supporting Asian US dollar bonds last year could continue to be a stabilising force going forward. Eighty per cent of corporate issuers in Asia cater to domestic demand, and despite some growth challenges in Asia ex-Japan, economic fundamentals in terms of reform progress, level of savings and external balances remain on sound footing relative to other emerging markets. The investor base for Asian bonds has also changed dramatically, with Asian-based investors now accounting for more than half of annual issuance. Moreover, the benign inflationary backdrop and sound fiscal positions in emerging Asia give Asian authorities more fuel for policy accommodation to spur growth.  

Although Asian dollar-based bond yields, at around 4.5 per cent, may not look as attractive compared to emerging market bond markets, we view that the current yield still provides a decent bond carry for the more defensive macroeconomic backdrop. The headline yield also belies pockets of opportunities in the Asian bond market which have emerged due to increased bifurcation within the market.  

Similarly in the local currency bond markets, while performance drivers are different from the US dollar bond market, we expect the generally stable economic backdrop and the accommodative monetary policy bias to be supportive of local bond markets in the medium term. The diverse domestic dynamics – for example, the differing levels of real rates, as well as stage of interest rate/growth cycles across Asia - are also providing selective value opportunities for local bond investors.

Are the asset allocation choices you are making hedged in any way? What sort of risks are you prepared for?

Given the fragile risk sentiment in the market, we are adopting a barbell strategy in terms of credit and interest rate risks. While we continue to like long-dated, high quality, investment grade corporates for their defensive qualities and relatively attractive valuations, we are also overweight the shorter-dated high yield bonds, which provide some yield pick-up, while lowering the overall portfolio duration. We may also use derivatives to hedge our interest rate and credit risks from time to time.

Which of your stances would you say are contrarian vis-a-vis other investors? 

While like many other investors we are adopting a more defensive stance in view of the uncertain market environment, we may see differently what is defensive. For example, we are actually overweight in certain longer-dated investment grade energy issues as we expect the issuers’ credit profile to remain intact, while the credit spreads have factored in more than the perceived risks, including rating downgrade risk.

As an investor, how are you dealing with heightened volatility and liquidity issues?

We view the balance of risk as more idiosyncratic than systematic, and we have focused on our overarching theme of differentiation and diversification. We believe that a careful selection of credits, as well as adequate diversification, could help mitigate price volatility due to credit events and on an overall portfolio level. Additionally, diversification of issuer risks also allows us to scale in and out of a position more nimbly, particularly during periods of market stress which could result in a drying up of market liquidity. We also remain mindful that certain market segments are less liquid and particularly vulnerable to freezing up during market stress, and hence we would be cautious in building up positions in less liquid assets.

What is your exposure to cash in percentage terms and has this changed recently?

Cash level for our Asian Bond Fund has been reduced from a peak of around 10 per cent in June 2015 to currently around 6-7 per cent of the portfolio. While the cash level is still relatively high compared to longer-term historical average, it reflects our view of a still-challenging macroeconomic environment. This is also in line with our strategy to gradually increase our exposures to selective investment opportunities which have been oversold relative to their fundamentals. We are patient in deploying the cash in a bid to avoid paying high transaction cost as bid-ask spread could be quite wide from time to time. More patience is also required in view of the slowdown in new issuance.

Where do you see value in the markets you operate in and why?

Market sentiment has dramatically improved since month end on the back of a rebound in oil prices, a robust set of February job numbers in the US and expectations of more stimulus measures from the Chinese authorities as well as their developed market counterparts. For our Asian Bond Fund, we would nonetheless stay on the defensive side as we expect risk markets to remain volatile. In this connection, we would continue to add investment grade credits to take advantage of the still steep credit spread curves. In the financial space, we would maintain our overweight in Asian bank sub-debt but may move up the capital structure and away from the most subordinated, the AT1, segment. 

While the spread differential between high yield bonds and investment grade bonds has narrowed considerably following the rebounds in high yield credits, the differential is still wide from historical perspective. We continue to see selective opportunities in the high yield space, such as non-commodity Indonesian high yield bond names. 

Who works with you in your team?

We have a highly experienced and cohesive investment team, made up of 14 investment professionals. A team-oriented approach is adopted in our research approach, ensuring that broad market and credit investment views are discussed actively during our investment meetings and in our day-to-day interaction. Out of the team of 14 investment professionals, seven of them are responsible for bottom-up credit research. Their credit research output forms an important part of our credit selection process and active discussion is usually undertaken between the portfolio manager and the analyst before a buy/sell decision is made. The team has collaborated successfully over many market cycles, boasting a low turnover rate and an average of 14 years of investment experience.