At GAM Investments’ Weekly Investment Meeting held on 5 December 2018 the speakers were Jonathan Stanford, who highlighted the opportunities in the convertible bonds sector, and Amy Kam, who discussed the prospects for EM Asia fixed income.
Convertible bonds (CBs) are a unique asset and represent different things to different investors, depending on your viewpoint. Usually, there are two types of investor here: those who play the asset class as a defensive equity position and the rest who view it as an enhanced bond position. So why do equity investors invest in convertible bonds? In our view this is because convertible bonds have yielded similar returns to equities on a mid-to-long term basis, but this has been achieved with a third less volatility. On top of this, when equity markets enter a distress environment CBs have historically shown they are able to weather the tough times owing to their fixed income traits. CBs rank high up in the capital structure, issued as senior unsecured debt, so are just behind bank loans and secured debt in the event of default, whereas equity comes last. This seniority proves handy in times of restructuring balance sheets, for example.
So why do bond investors like convertible bonds? We believe, first and foremost, that this is because they are bonds and have the aforementioned seniority. In addition, they have a lower duration than the average fixed income asset class, offer interesting M&A opportunities and there is the additional bonus of their equity participation. It is also a broader opportunity set, offering newer and wider ideas in credit from issuers that are not present in other fixed income asset classes.
A broader argument in favour of CBs is that they have traditionally performed well in rising interest rate environments due to their low duration and offer fixed income buyers diversification in such conditions. One of the key factors behind this, in our view, is that interest rates generally rise during times of expanding economic conditions, which often leads to rising equity markets, a trend in which CBs have been shown to participate.
That said, 2018 has been a time where CBs have experienced a drawdown, but for us these reduced prices signify a more attractive entry point to the market. We believe that out-of-benchmark issues overlooked by the market offer interesting opportunities going forward. European equities have witnessed a sell-off in light of Brexit and Italy, but whether this represents an investment opportunity or not, only time will tell. However, we believe that a solid allocation to CBs can provide opportunities for every asset allocator, be it equity, bond, or cross-asset.
EM Asia fixed income
Asia has once again proven to be a low beta emerging market (EM) bond play. Year-to-date, investment grade bonds in the region are more or less in line with the broader EM, but high yield has underperformed both the US and other EMs. We believe this is due to a combination of factors. First, there is heightened risk concentrated on China given the trade war talks and the past two years of deleveraging efforts from the government, which has highlighted risks of high corporate leverage. Another reason is particularly heavy supply from the primary market. Statistics show that in Asia this year gross new corporate issuance has been close to twice that of all other EMs combined. Our base case assumptions are that Beijing will be effective in managing external challenges and the slowing of growth; whereas trade talks between China and the US will be a long, drawn out process.
In our view there are three key opportunities in the emerging Asia bond space. 2018 has not been very kind to EM, like everywhere else, but the positioning is now cleaner and the fundamentals stack up. We believe the first opportunity is the China onshore bond market. At USD 12 trillion it is the third largest in the world and we feel is a great opportunity for diversification given its low correlation to the offshore US dollar China credit market as well as developed market core rates. Different credit cycles on and offshore has driven favourable cross-currency hedging opportunities to lock in attractive US dollar yields. China onshore bonds are also about to be included in major global indices which, alongside favourable tax treatment for foreign investors, is also helping to attract international inflows. Currently international participation stands at around 3 to 4%, so there is plenty of scope for this to increase. Chinese government bonds’ stand out performance year-to-date highlights the aforementioned low correlation.
In our view, the next opportunity is local government financing vehicles (LGFV). LGFV existed for legacy reasons because local governments historically are not allowed to have a budget deficit and therefore utilised such vehicles. It is recognised by the IMF that the vast majority of infrastructure investments happen at local government level, and at this juncture we believe LGFVs will continue to play an important role in infrastructure investments. Moreover, the USD LGFV curve responded to the recent policy change in July by tightening over 100 bps, but the US dollar spread remains at an elevated level relative to regional rating peers and importantly its onshore spread curve, hence a compelling risk reward opportunity, in our view.
We believe the third opportunity is property. China’s housing reform in the mid 1990s, combined with rapid economic growth and urbanisation, fuelled the development of its residential property market. China’s housing ownership is already high, while additional demand drive from urbanisation is waning. Beijing has recognised signs that the market overheating, and we believe the stringent property curbs are here to stay, for now. However, we do not see an imminent housing market crisis because the critical ingredient for a crisis, either a stretched housing or banking sector leverages to property, is not there. China’s consumer leverage has increased dramatically over the last couple of years and we believe this is a risk to monitor, as China has no experience in dealing with household debt crisis, but neither is excessive by global standards. On the other hand, the importance of property sector to the economy cannot be overstated. Property construction remains very important to the economy, representing some 20 to 25% of GDP; the combination of land sales and property-related tax contribute 30% to local government budgets; and the banking sector’s exposure to the property sector is close to 30%, both directly, via construction loans and mortgages, and indirectly, with loans to corporates often collateralised by land and property. Given the above, and the dramatic correction in valuation, we see the sector’s double digits average yield as compelling on a risk/reward basis. Lastly, of note is that Moody’s covenant scoring for the Chinese property sector is superior to the global average.
Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a security is not a recommendation to buy or sell that security. Allocations and holdings are subject to change. Past performance is no indicator of current or future trends.