For several years, investors struggled to find income without taking on risk that was often beyond their comfort zone. But as the US Federal Reserve and other central banks raised interest rates in response to rampant inflation, bond yields rose across the curve and income-starved investors were presented with opportunities.

Of course, near double-digit inflation rates across the world mean compelling nominal yields are less appealing in real terms. Nevertheless, if the actions of central banks to curb price rises prove effective and inflation subsides, then locking in high income now might turn out to be a shrewd decision.

On the other hand, if tight monetary policies inadvertently provoke a recession, then fixed income investors would face another threat: deteriorating earnings for corporate borrowers. Mindful of this danger, most investors and fund selectors in Asia seem to be confining their bond exposure to only the best quality investment grade credits.

For instance, China property high yield bonds, which comprise most of the Asia fixed income universe, have few fans, although increasingly the market is differentiating between borrowers that are viable and those that will struggle. Arguably, emerging market bonds from other jurisdictions offer better value.

Meanwhile, the wipeout of Credit Suisse’s AT1 bonds following the bank’s takeover by UBS has sparked concerns about the desirability of low-ranking capital bonds issued by all but the best banks.

Another prominent theme, as always, is ESG. Fixed income funds managed according to ESG or sustainability criteria are certainly gaining traction in Asia, as elsewhere in the world, but the availability of reliable, accurate data is still a problem.

All these topics and more are examined in this special Citywire fixed income issue. We hope you enjoy it.

The ramifications of the decision by the Swiss Financial Market Supervisory Authority (Finma) to wipe out Credit Suisse’s $17bn of additional tier-1 (AT1) bonds were immediate and are likely to be enduring.

Ten days after the 19 March announcement was made that the bonds were worthless, an Invesco exchange-traded fund tracking AT1 debt had fallen 19%. At the beginning of April, Mitsubishi UFJ Financial Group postponed its planned issuance of AT1 debt, citing poor investor appetite and dire market conditions.

As PGIM Fixed Income portfolio specialist Gabriel Doz told Citywire Asia: ‘The AT1 bank debt market is now in a coma.’

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‘The yields were attractive, but we never went down the capital structure on banks’

^{Gabriel Doz, PGIM Fixed Income}

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Capital structure ambiguity

Also known as contingent convertibles, or Cocos, AT1 bonds can be converted into equity if capital ratios fall below a certain level or are written down entirely. The bonds form part of a bank’s tier-1 capital, the core measure of a lender’s financial strength, which also comprises common equity tier-1 capital.

Doz noted that the AT1 wipeout, which formed part of Credit Suisse’s enforced takeover by UBS, only affirmed PGIM fixed income’s stance of staying away from the sector. ‘The yields were attractive, but we never went down the capital structure on banks,’ he said.

The $275bn AT1 sector is a product of the global financial crisis in 2008, derived from regulators’ desire for banks to move risk away from depositors and to have greater capital requirements in case of failure. AT1 bonds typically pay higher yields and are periodically called, giving investors the possibility of an early exit.  

Although debt typically ranks above equity in a restructuring, Finma overturned the order of priority by giving CHF 3bn ($3.3bn) back to Credit Suisse shareholders while wiping out AT1 bondholders.

‘The Credit Suisse acquisition raises questions on the positioning of AT1 in the capital structure,’ said Riad Chowdhury, head of Apac, MarketAxess, in a note.

Indeed, the AT1 bond market faces a ‘risk premium repricing’ in the wake of Credit Suisse’s debt being written down ahead of equity. Some banks will struggle to issue and others will pay a much higher price to tap the market.

Kian Abouhossein, European banking analyst at JP Morgan, noted that most banks were paying 8-10% coupons for AT1 bonds but should brace themselves for this potentially rising into double digits.

AT1 bonds are perpetual, meaning the borrower has no obligation to repay investors. However, banks typically refinance the bonds with new issuance once an initial ‘non-call period’ has expired, providing flexibility to investors who can decide whether to invest in the new debt.

More than $37bn worth of AT1 debt issued globally has call dates in April, according to Refinitiv data. If banks decide not to call their debt, yields in the AT1 market could surge even higher.

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‘There is going to be a heightened focus on investing in the strongest banks’

^{Riad Chowdhury, MarketAxess}

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Asia bank issuance

Yet, despite the shock to the wider market, the reverberations in Asia Pacific have so far been muted, notwithstanding the delay in Mitsubishi UFJ’s launch.

Asia’s AT1 bond prices dropped 4.3% on average, lower than the double-digit declines in many other markets, according to data compiled by Natixis Corporate & Investment Bank between 17 and 21 March.

‘A lot of the AT1 issuance within Asia had a huge derating, [and] we thought there were opportunities,’ said Omar Slim, co-head of Asia ex-Japan fixed Income and portfolio manager at Pinebridge. ‘But the timing has passed in the sense that the selloff in Asian financials was really short-lived and came about very quickly. There was a window of only three or four days.’

There are $69bn worth of outstanding US dollar-denominated AT1 bonds from Asian Pacific banks, according to Goldman Sachs estimates, with mainland Chinese institutions accounting for 41% of the total. European banks account for the majority of the bonds outstanding.

‘Immediately [after Finma’s decision], there was a sharp selloff in AT1 bonds of Asian issuers as investors panicked that these securities could be subordinated to equities in certain situations,’ said Chowdhury.

Although prices recovered, he warned that ‘there is going to be a heightened focus on investing in the strongest banks’.

Indeed, Natixis also cautioned: ‘A likely scenario is the financial sector will need to pay a higher cost when raising capital, which will also affect Asia, and it can lead to a selective approach and more constraints on credit growth ultimately.

‘There is also likely to be a re-pricing of the asset class where increasingly investors will compare AT1 yields to the cost of equity. This repricing of AT1 securities will likely cause some issuers (certainly the weaker ones) to consider calling back their AT1 bonds and consider other sources of (cheaper) capital,’ said Natixis.

‘This might reduce the investable universe of AT1 bonds available to Apac-based investors,’ said Chowdhury.

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‘The bonds were sold on the promise that they were high yielding and safer than equities, but it has been a rude awakening for private banking clients and advisers’

^{Singapore-based private banker}

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Regulatory reassurances

Regulators elsewhere, however, have distanced themselves from Finma’s decision, which might calm investors and reopen the AT1 market for issuers.

The Swiss regulator said the Cocos issued by Credit Suisse ‘contractually provide that they will be completely written down in a “viability event”, in particular if extraordinary government support is granted’.

Emergency government loans were granted to the Swiss bank on 19 March as part of the financing package for UBS’s $3bn takeover, triggering the viability event clause.

However, the European Central Bank (ECB), Monetary Authority of Singapore (MAS), Hong Kong Monetary Authority (HKMA) and Bank of England (BoE) have publicly stated they will rank AT1 holders above equity investors.

‘Shareholders are the first ones to absorb losses, followed by holders of AT1 and tier-2 capital instruments,’ HKMA said in a statement.

BoE governor Andrew Bailey said that ‘in any resolution we will always abide by the creditor hierarchy because that’s a cardinal principle’, while the ECB affirmed that ‘common equity instruments are the first ones to absorb losses’.

‘It was very positive for the market as well as for Asian issuers and investors, that the ECB confirmed that CET1 would be the first to take losses and that it would not be following what the Swiss did,’ said Chowdhury.

MAS joined the reassuring chorus by stating that, in exercising its powers to resolve a financial institution, it intends to abide by the hierarchy of claims in liquidation.

MAS also clarified that AT1 bonds in Singapore are offered in the wholesale market, which is only for institutional and accredited investors, in transactions of at least S$200,000 ($150,600). It said that no prospectus for the offering of AT1 bonds to retail investors has been registered with the MAS.

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‘Shareholders are the first ones to absorb losses, followed by holders of AT1 and tier-2 capital instruments’

^{Hong Kong Monetary Authority}

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Recovering losses

However, it is unlikely that all institutional and accredited investors will resign themselves to their losses.

‘The decision by the Swiss regulator and the subsequent impact it has had on the market has caused anxiety among private banks who were pushing these products to their wealthy clients,’ a Singapore-based private banker told Citywire Asia.

‘The bonds were sold on the promise that they were high yielding and safer than equities, but it has been a rude awakening for private banking clients and advisers,’ he added.

Some holders of Credit Suisse’s AT1 bonds have instructed law firm Quinn Emanuel Urquhart & Sullivan to represent them in discussions with the Swiss authorities and possible litigation to recover their losses.

Clearly, the consequences of Finma’s action have not yet fully played out.

Taking a line from the iconic spy thriller series, fund selectors are saying: ‘The name’s Bond’. Of course, not James, but high-grade bonds.

After a historically bad year in 2022, fixed income has rallied strongly in 2023. Despite an environment of steadily rising interest rates and inflationary concerns, bonds are once again on the radar of investors as they continue to offer attractive yields, although the recent US banking crisis has taken a little of the sheen off them.

According to data from Bloomberg, the yield on the 10-year Treasury note is hovering in the vicinity of 3.5% after the Federal Reserve announced yet another 25-basis-point rate hike in March. Investors also have opportunities in short-duration fixed income, with six-month and two-year Treasuries yielding 4.76% and 4.1% respectively.

‘Longer-duration quality bonds in US dollars for a part of the fixed income allocation look attractive, helping to mitigate reinvestment risk,’ said Rishabh Saksena, head, investment specialists Apac, Julius Baer.

Echoing a similar sentiment, UBS Global Wealth Management’s (UBS GWM) Jansen Phee, head of fund investment solutions Apac and head of global investment management China, said: ‘High-grade and investment grade bonds remain attractive as defensive assets.’

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‘Longer-duration quality bonds in US dollars for a part of the fixed income allocation look attractive, helping to mitigate reinvestment risk’

^{Rishabh Saksena, Julius Baer}

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Rate-hike cycle ending

When making its ninth hike since March 2022, the Federal Reserve Board’s rate-setting open market committee noted in its most recent announcement that future interest rate increases were not certain and would depend largely on incoming data.

Many fund selectors spoken to by Citywire Asia believe the Fed will stop cutting interest rates before the year-end and yields will start falling.

RBC Wealth Management said it believed the Fed’s rate hike in the third week of March would ‘be either the last or second to last one of this rate-hike cycle’.

Ken Peng, head of Asia investment strategy at Citi Global Wealth Investments, said: ‘We expect the US Federal Reserve to end its rate hikes by May, and 10-year US Treasury yields may fall below 3% before the end of this year.’

And in its April outlook, Standard Chartered Wealth Management said it expects the 10-year US government bond yield to fall to 3.25-3.5% by end-June and 2.75-3% by year-end, so it is raising exposure to high-quality government bonds.

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‘We expect the US Federal Reserve to end its rate hikes by May, and 10-year US Treasury yields may fall below 3% before the end of this year’

^{Ken Peng, Citi Global Wealth Investments}

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Selective and defensive

So what are Asian private bank clients looking for in fixed income allocations?

Peng said fixed income was viewed both as a flight to safety and as an opportunity to lock in income for wealthy clients. ‘But for the next three to six months, it’s important to stay very high quality as credit risk may rise further while risk-free rates fall,’ he said.

The recent increase in US Treasury yields enabled meaningful returns in the fixed income market, said Julius Baer’s Saksena. ‘While one could argue prevailing higher inflation implies lower real yields, the impact of aggressive monetary tightening on aggregate demand should help moderate inflation going forward,’ he said. ‘This backdrop provides a good opportunity for Asian clients.’

Phee said that aside from adding carry yield to a portfolio, fixed income as an asset class offered stability in times of economic uncertainty and the potential to generate higher total returns in a recession scenario, where anticipated rate cuts would lead to a drop in bond yields and an increase in bond prices.

However, there are still risks to increasing exposure to fixed income. There may be a deterioration in credit quality of bond exposures in case of a recession, for example, and higher interest rates if inflation turns out to be stickier than expected. ‘Credit risk is likely to rise during a recession,’ Peng warned.

Saksena said that dollar-denominated longer-duration quality bonds could be complemented by select lower-quality investment grade bonds of shorter duration.

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‘Fixed income as an asset class offered stability in times of economic uncertainty and the potential to generate higher total returns in a recession scenario’

^{Jansen Phee, UBS Global Wealth Management}

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China property bonds

In January this year, bonds issued by China’s real estate developers rebounded sharply after the government offered an industry rescue package and reopened the economy and borders swiftly. This seemed to have kindled some bargain-hunting among investors.

There had been positive signals suggesting ample availability of mortgage loan disbursement, said UBS GWM’s Phee. Housing data in the early months of 2023 also showed a recovery in the physical transaction side.

‘However, recent earnings results from Chinese property developers and property management firms have been weak and largely below expectation. Therefore, we remain selective on investment grade bonds while remaining cautious on lower-rated bonds,’ he said.

Peng believes that as more defaulted issuers restructure, the market should become more stable. ‘The rebound in property sales is relatively strong and should serve as a support for the sector. But the opportunity is likely only cyclical, whereas the long-term prospect for the sector remains challenging.’

The wild swings seen in fixed income as investors grapple with stubbornly high inflation, further rate hikes and a potential recession underline just how brittle confidence remains.

The return of bonds as a viable diversifier had been loudly proclaimed by asset managers since the tail end of 2022 through January, when markets rallied sharply. But after the selloff during the past two months, sparked by changing expectations on monetary policy and fears of a banking crisis, caution is once more the watchword.

‘We have adopted a defensive investment stance for the next six to 12 months as the economic cycle in the US and Europe peaks,’ said Steve Brice, chief investment officer at Standard Chartered Bank.

The Asian lender has been increasingly bearish on the economic outlook, with Brice consistently warning about the risks of a US recession.

He believes the weakness in the American regional banking sector following the collapse of Silicon Valley Bank (SVB) could prove to be a harbinger of the downturn, forcing the Federal Reserve to pivot and cut rates before the year end.    

Amid the uncertainty, Standard Chartered moved overweight developed market government bonds and US dollar-denominated Asian bonds, where spreads have widened after Treasury yields fell, in early April.

‘The Asian US dollar corporate bond market is overwhelmingly investment grade, which helps in an environment where the US and Europe face elevated risks of a recession,’ Brice said.

‘These bonds are also likely to benefit from an expected upturn in corporate earnings in Asia on the back of China’s reopening. China’s economy is at the opposite end of the spectrum versus the US and Europe – economic growth in China is expected to accelerate to more than 5% this year, helping repair and strengthen regional corporate balance sheets.

‘This upturn is likely to filter through to Asian USD bond prices.’

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‘We have adopted a defensive investment stance for the next six to 12 months as the economic cycle in the US and Europe peaks’

^{Steve Brice, Standard Chartered Bank}

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Quality control

Brice recommends investors sit in higher-quality-yielding assets to ride out any future shocks as the macro-storm clouds gather. For all the ructions in the market since the turn of the year, a buy-and-hold strategy would have delivered solid if unspectacular gains in the first quarter. Global investment grade, US Treasuries and high yield all delivered about 2.5% in total return terms, according to Bank of America data.

Many expect a divergence through the rest of the year, however, and the focus on ‘quality’ is a major theme in asset managers’ second-quarter outlooks. The word peppers market commentaries, and HSBC Asset Management head of Asian fixed income Elizabeth Allen expects this to continue, at least in the near term.

‘While we have expected to see market volatility in the first half of 2023, the movement, especially in the US rates market, has been particularly drastic,’ she said. ‘We have been maintaining a quality bias in our portfolios generally and also watching our exposure very closely so as not to take excessive risk during a period of high volatility.’

At a sector level, HSBC AM has been favouring consumer names benefiting from the reopening of Greater China. It has also been backing long-term structural growth plays in India and Indonesia, including companies tapping into the green energy theme.

Allen said she had been able to pick up some ‘selected quality bonds at attractive valuations’ during the selloff. She is wary of bank debt after the collapse of SVB and the Swiss National Bank’s controversial decision to wipe out $17bn of Credit Suisse AT1 bonds as part of its forced marriage with UBS.

‘With the US and European banks at the centre of the storm, their Asian counterparts are subject to a different set of macro, regulatory and monetary conditions,’ Allen said. ‘[We] focus our investments on the stronger banks and bonds with stronger protection.’

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‘We think the BB market offers a sweet spot for corporate bond fund managers, where they can capture some of the yield from non-investment grade debt without taking exposure to as many “blow-ups”’

^{Peter Harvey, Schroders}

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Casting the net wider

Some investors are moving further down the credit spectrum, with Schroders arrowing in on so-called crossover bonds to scoop up chunkier yields. Sitting in the borderlands of investment grade and high-yield, these bonds, mainly BB rated, are underresearched, according to Peter Harvey, a credit portfolio manager at the British fund house.

‘We think the BB market offers a sweet spot for corporate bond fund managers, where they can capture some of the yield from non-investment grade debt without taking exposure to as many “blow-ups”,’ he said.

Harvey points to yields north of 7%, with a long-term average default rate of 1% and a broad mix of sectors and investments. These range from fallen angels to leveraged buyouts and subordinated financials, spread across the whole gamut of industries.

Standard Chartered is cautious on dipping into high-yield though, being underweight both US and Asian high yield on concerns about slowing global growth and rising refinancing costs.

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Have you raised your allocation to emerging market bonds? If not, what would be the catalyst for you to do so?

We believe that 2023 will be a good year for fixed income, with bonds expected to outperform as recessionary risks increase. Within fixed income, we favour investment grade credit, particularly US and Euro credit based on strong fundamentals and high yields and spreads, leaving room for spread compression.

We also like emerging market (EM) bonds, both in local currency and US dollar-denominated. We prefer commodity exporters and high-quality issuers, and expect that the resumption of activity in China will support EM assets in general.

Among EM bonds, we are particularly positive on Indonesia. We expect Indonesia’s economy to gain momentum on further reopening and the government to follow through on reforms and infrastructure projects. As China continues to reopen, we expect strong commodity demand to support the Indonesian rupiah. Apart from the sovereign, we also remain comfortable with Indonesian state-owned enterprises in the infrastructure space.

Finally, with China ending its zero-Covid policy and having supportive policies for the property sector and encouragement for foreign investment, we are now also starting to turn more constructive on China.

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Have you raised your allocation to emerging market bonds? If not, what would be the catalyst for you to do so?

Our preferred allocation in EM debt is to EM local currency bonds. EM local currency debt provides investors with non-US dollar foreign exchange (FX) exposure as the US dollar bear market looks set to resume. Providing a modest premium to US government bonds, a pause in the Fed hiking cycle, which we expect later this year, should provide a catalyst for strengthening EM FX rates against the US dollar and provide portfolios with an alternative source of return beyond the high volatility we are seeing in the wider US dollar bond market currently.

In contrast to this ‘FX carry’ opportunity from EM local currency bonds, EM US dollar investment grade exposure offers limited pickup versus broader US dollar investment grade yields. Although EM high yield bonds offer a cyclically large premium to US high yield bonds, the exposure to the ongoing restructuring of the Chinese property sector suggests caution is warranted for global investors.

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The long drawn out property sector crisis continues to roil China’s $735bn offshore bond market, despite an 80% sentiment-driven rally in Chinese high yield dollar bonds from November through January.

The rally has since fizzled out, even as distressed developers outline some progress with their debt restructurings. China Evergrande, the world’s most indebted property developer, finally unveiled plans to restructure $19bn of its offshore debt in early April after repeatedly missing its own self-imposed deadlines earlier.

China Evergrande sees the development as a ‘substantial milestone’, but PineBridge’s Omar Slim believes it’s only a marginally positive move. Having resolutions with some of the distressed developers could remove the overhang, but it was not a game changer, said Slim, PineBridge’s co-head of Asia ex-Japan Fixed Income and portfolio manager.

‘To have another leg higher, you need to have some fundamental data improving. You need to have sales in China pick up and you have to see some stabilisation in terms of prices. You have to essentially see some activity, which [nevertheless] is coming back,’ said Slim.

In March, China’s home sales rose for a second straight month, climbing 29.2% from a year earlier to RMB 660.9bn ($96bn). That followed February’s sales, which saw the first increase in 20 months, pointing to signs of the housing slowdown abating. The uptick was also reflected in new home prices rising after months of negative growth.

Activity is likely to improve in the second half of this year, but Slim cautioned: ‘This does not mean some of the distressed names are going to come back from the land of the dead. The reality is, frankly, a large part of that segment is gone. A lot of developers are gone and that market will continue but will be much smaller than it used to be.’

According to Morningstar data at the end of December, PineBridge’s Asian High Yield Total Return strategy held Chinese developers including Road King Infrastructure, Country Garden, Yanlord Land (HK), and Seazen Group.

Paradoxically, as the housing sales data accumulates, it becomes more difficult for certain developers to survive, said Slim. ‘If you continue to see that divergence between developers − if you are a home buyer in China, you’re not likely to buy an apartment from [stressed names] − that becomes a self-fulfilling prophecy accelerating their demise. That’s a big risk for some of them,’ he said.

China’s surviving developers

The survivors in China’s property market will also become more apparent.

‘There may be a bifurcation of currently performing [Chinese property] bonds and those bonds that have defaulted and are going through restructuring,’ said Wai Mei Leong, Eastspring Investment’s fixed income portfolio manager.

‘The performing names may rerate higher if the physical market recovers meaningfully in the latter part of the year, while the defaulted/restructured names may still face challenges in accessing funding in order to complete their ongoing or stalled projects,’ said Leong.

The market was at a crossroads, reviewing and rethinking which companies were positioned to endure in the longer term, such as those positioned with tier-1 property projects or those with more commercial properties with rental returns, Leong said.

The consolidation was likely to continue until a sustained recovery in primary home sales was observed, said Judy Kwok, Manulife Investment Management’s head of Greater China fixed income research.

‘Initial excitement at the comprehensive supportive package to the sector by the government has largely been digested,’ Kwok said. ’After we see the government’s support toward the funding environment for the property sector, the market needs to see fundamental improvements.’

China’s property high yield (or junk) bond rally earlier had been galvanised by Beijing’s bevy of support measures for the crisis-hit sector. Authorities softened the ‘three red lines’ rules in January to ease the liquidity crunch for certain property firms following last November’s sweeping relief package.

The recently concluded annual meeting of China’s parliament in March also underscored Beijing’s intention to prevent the sector’s disorderly behaviour while rolling out incremental measures to support developers’ funding access and improve home-buying activity.

‘These policy announcements strengthened our conviction that there will be some survivors among Chinese developers,’ said PineBridge’s Slim.

‘Towards the end of the third quarter last year, the selloff was completely indiscriminate, where all the names were becoming distressed regardless of what the fundamentals were,’ he said. Beijing’s support measures had allowed the market to be more discerning, affirming Slim’s view that the stronger names would be able to survive.

The property sector recovery should first come from the secondary market, followed by improved primary sales by stronger players such as state-owned enterprises, said Kwok. Private-owned enterprises would lag behind in sales recovery.

Other early signs of the market healing were the higher visitation and better secondary market transaction volume, Kwok said, but ‘it is still too early to call it a sustainable recovery trend’.

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‘It is still too early to call it a sustainable recovery trend’

^{Judy Kwok, Manulife Investment Management}

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Bargain hunting

Still, the attractiveness of China’s high yield bond markets beckons investors.

Yields on an ICE BofA index tracking China high yield companies moved higher to about 20% at end March, having dropped to around 16% in February. ‘Investors are very interested in the China high yield bond market given its attractive relative value, but some international investors are cautious given the remaining fundamental weaknesses,’ said Manulife IM’s Kwok. China’s reopening remained a major investment theme this year even as global headwinds persisted, she said.

As for PineBridge’s Slim, he noted more investor interest for the Asian high yield sector coming out of Europe, with investors dipping their toes back into the market, possibly because of having ‘quite a bit of ammunition’.

‘The frank reality is that some investors have been burned, particularly in this part of the world. These folks are not likely to be engaged with the market quickly because it has left a bitter taste in the mouth,’ Slim said.

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‘The frank reality is that some investors have been burned. These folks are not likely to be engaged with the market quickly, because it left a bitter taste in the mouth’

^{Omar Slim, PineBridge}

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Macau’s revival

Within the broader Asian high yield bond market, as investors seek exposure beyond Chinese junk debt, an area recapturing attention is the beaten-down Macau gaming bond sector. ‘It offers good value because some overhang by licensing [concerns] is completely cleared, while [serving as] a good diversifier,’ said Freddy Wong, head of Asia Pacific fixed income at Invesco.

Macau’s gaming revenue surged to a three-year high in March as the city enjoyed a resurgence of tourists from the mainland. Local authorities had in November renewed licences for six incumbent operators in exchange for investments into non-gaming sectors as part of Macau’s tighter regulatory oversight of gambling.

‘The whole industry relies not just on gambling, but also on tourism. [Macau gaming names] have a healthy financial profile with a high level of interest coverage ratio,’ said Wong, while noting the high-end VIP segment remains lacking.

Manulife IM’s Kwok sees good value in Macau gaming bonds too, but expects it will take one or two years for credit fundamentals to fully recover.

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Have you raised your allocation to emerging market bonds? If not, what would be the catalyst for you to do so?

Hit by hawkish Fed rate hikes in 2022, emerging market (EM) hard currency corporate bonds delivered their worst total returns since 2008, down by 13.8% last year. We expect an improved investment outlook for EM bonds in 2023 as the US rate-hiking cycle is approaching its end by the middle of this year and EM credit fundamentals remain strong. The overall EM bond market, especially Asia credit, should benefit from China’s growth recovery, the peak in the US dollar and US Treasury yields, the imminent end of the Fed's policy tightening, conservative investor positioning, and appealing valuations.

Since the beginning of this year we have maintained an overweight allocation to EM corporate debt to capture their attractive spreads. But we remain selective, with a strong focus on higher-rated quality issuers within those markets. Excluding Chinese property developers and Russia-Ukraine issuers, EM high yield corporate default rates remain comparable with US high yield at 1.8%.

We are overweight on Asia investment grade bonds and higher-rated issuers from the Middle East, Brazil and Mexico. We selectively invest in strong credits issued by EM commodity producers and financial and technology companies. In China, we prefer Chinese state-owned developers, technology bonds and quality financial credit.

We stay neutral on the EM local currency debt market as elevated global risks and rate volatility add pressure on EM nations’ fiscal and current accounts. We will wait for improvement in the global cyclical outlook, recovery in investor risk sentiment, and further weakening in the US dollar as catalysts to raise our tactical allocation to EM local currency debt to an overweight from neutral.

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Have you raised your allocation to emerging market bonds? If not, what would be the catalyst for you to do so?

EM credits have historically been more sensitive to global risk-offs and with higher correlation to equities, calling for added defensiveness from an overall portfolio allocation standpoint. Credit spreads have staged a strong rally since October and we recently trimmed our EM exposure, cautious on valuations. But we expect most of the EMs to continue growing through 2023 despite the expected slowdown across the US and major European economies, and we will increase allocations once we find better entry levels. Geopolitical risks are still something to monitor, but macros remain supportive for many of the stronger EMs, particularly the ones in Asia.

Asian quasi-sovereigns remain among our preferred pockets, continuing to offer attractive pickup over comparable developed market peers across shorter tenors. Dominated by higher-rated single-A/AA credits, Middle-Eastern credits also remain key diversifiers for us, adding better resilience to portfolios on the downside. Africa remains a landmine (or a goldmine full of tactical opportunities), but calls for extra tact and caution. Political developments dominate the LatAm space and we have seen some noise settling there, and while hard currency credits are currently looking tight, the sharp policy rate hikes are now making US dollar-funded carry trades look attractive for local currency exposures.

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Investors are confident that ESG and sustainable bonds will bounce back after a torrid 2022, citing rising demand and significant global regulatory drivers.

Fixed income markets were hit by rapidly rising interest rates amid soaring inflation, sparking one of the worst-ever selloffs last year.

Sustainable bonds were among the hardest hit, notably underperforming their traditional counterparts for the first time since 2018. The S&P Green Bond index, which tracks about $1.4tn in bond issuance from governments, agencies and companies worldwide, fell by 20.1% in 2022, compared with a 16.7% drop in the wider global investment grade universe.

Morgan Stanley put a lot of this underperformance down to sustainable bonds’ typically longer duration, with the S&P Green Bond index having an average duration of 10.5 years.

‘In fixed income, the broader market response to increasing rates in 2022 favoured funds focused on shorter durations. This investor shift impacted sustainable funds, which tend to skew toward long durations,’ the bank said in a note.

‘Also notable is that green bonds tend to favour utilities and financials, which both underperformed in 2022.’

ESG bond issuance also fell against the tough market backdrop – exacerbated by scepticism about the effectiveness of sustainability-linked bonds (SLB) – slumping 33% on the year to $750bn, according to S&P data.

Brighter outlook

Despite the storm clouds over the market, demand remained strong. Globally, ESG bond funds saw inflows of $21bn in 2022, compared with $499bn in outflows from traditional bond funds, according to Bank of America. Total ESG fund assets still dropped to $490bn, though, down from $545bn in 2021, due to the market moves.

Bulls point to cheaper valuations after last year’s selloff and signs that inflation has peaked, raising hopes that the end of the rate-rising cycle is in sight, which will provide a more positive macro backdrop.

Johann Plé, green social and sustainability bonds strategy manager at Axa Investment Managers, believes there are ‘reasons to be optimistic about the asset class’.

‘The long-term picture looks more and more compelling for the bond market and should be particularly beneficial to the green social and sustainable bond universe given its credit exposure and sensitivity to interest rates,’ he said.

Plé is also backing mounting regulatory momentum and growing awareness of social and climate challenges to boost demand.

This is echoed by Julien Bras, socially responsible investing fixed income portfolio manager at Allianz Global Investors.

‘Demand from investors for more ESG fixed income opportunities is growing globally, especially as investors and regulators have increased pressure for companies to carry out better disclosures and practices,’ Bras said.

Rising demand

S&P predicted last month that green, social, sustainable, and sustainability-linked bond (GSSSB) issuance will increase by 5-17% to $900bn-$1tn this year, close to the record $1.06tn issued in 2021. This compares with the research house’s expectations of a 2.5% increase in issuance in the wider global bonds market and would see ESG-focused bonds account for 14-16% of total bond supply.

Doubts remain about the SLB sub-sector (bonds linked to specific sustainability objectives). Issuance dipped 25% last year on worries about ‘the credibility of the asset class’s ability to achieve meaningful sustainability targets’, S&P said. But the ratings agency believes the greater flexibility and simplicity that the bonds offer could still help ‘broaden the base of issuers of sustainable debt… if credibility is addressed’.

Even with concerns about SLBs, the signs for the wider ESG bond market are encouraging this year. TD Waterhouse highlighted a 40% year-on-year increase in global ESG bond issuance to $93bn in February. Corporate supply rose 51%, while green bonds accounted for 55% of overall supply, up from a long-term average of about 40%, as SLB demand remained subdued.

The slew of green bond issuance included a $5.75bn raising by Hong Kong in January, the highest ever for a sustainable bond in Asia. India pulled about $1bn into its first-ever sovereign bond and countries as diverse as Slovenia, Ireland and the Philippines also came to market.

Axa IM counted 115 new corporate issuers of green and sustainable bonds last year, adding depth to the market. Plé said there was notable issuance in the real estate, consumer goods, automotive and telecoms sectors, helping managers to build diversification.

Challenges still remain for ESG bond fund managers, however, as was seen last year in their relative performance.

Mitch Reznick, head of sustainable fixed income at Federated Hermes, emphasised the importance of the universe becoming deeper. He said: ‘[Sustainability]-themed funds will have sector biases in the short term versus a mainstream benchmark, [so] there will be some level of performance volatility.’

Archie Beeching, director, responsible investing at Muzinich, believes that disclosure also needs to be addressed. He said: ‘There is plenty of data for investment grade issuers, including in emerging markets, but less so the further down the credit spectrum you go,’ and in private companies.

There are multiple regulatory initiatives under way that should improve demand and existing challenges such as disclosure.

The EU reached a provisional agreement on a European green bonds standard in March, designed to provide a ‘green standard’ for transparency. The likes of Brazil, Thailand, Malaysia and Columbia are also working on taxonomies to ensure products are properly defined.

Elsewhere, Axa IM expects the US Inflation Reduction Act to drive higher issuance by incentivising corporates to change their behaviour.

The top performers chart for the past year is dominated by emerging markets and high yield bond funds. The period takes in many of the precipitous falls in the fixed income markets through 2022 as rates rose aggressively to combat soaring inflation, as well as the rally and subsequent volatility of this year.

High yield was aided by being short duration as rates increased, while many emerging markets funds were able to profit from the falling US dollar.

We have scoured all of the fixed income funds available to Hong Kong and Singapore investors to identify the best 20 performers over the past 12 months. Here are the results:
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