Fixed Income Market Update
In our latest Q&A, Portfolio Manager Teresa Kong, CFA, provides her insights on the timing of tapering, lessons to be learned from the ongoing saga of Evergrande as well as areas of risks and opportunities.
Markets now know that the taper can be divorced from interest rate hikes. But for how long? What are your expectations on the timing of tapering?
Rate hikes are more determined by fundamentals of the economy. Tapering is more about managing liquidity in the short-term funding markets. So a taper can be divorced from interest rate hikes indefinitely. The Fed’s assessment on whether the current inflation rate is temporary or persistent will be key. They have reiterated that they need to see inflation above their long run target of 2% for a sustained period of time before raising interest rates. I believe the current inflation might not be as short lived as what the Fed is signaling to the markets and we might be seeing interest rate hikes sooner than what the market is pricing, which appears to be around one year from now.
Where do you see the 10-year Treasury yield at year-end?
Our traditional models have deviated from reality since the onset of the COVID pandemic. The start and stop nature of the global economy resulting from the lockdowns have caused traditionally reliable signals like global purchasing manager index (PMI), an index of the prevailing direction of economic trends in the manufacturing and service sectors, to be less useful. As such we’ve been watching inflation and inflation expectations; the size of stimulus package(s) that Congress will (or will not) pass; and the ongoing spread of the coronavirus and various mutations. Due to the uncertain nature of these factors, the variance around our forecast has also increased. Our estimate today is 1.5% to 2.0%.
What does the financial woes of one of China’s largest property developers, China Evergrande Group, say about leverage in the country’s real estate industry and financial system?
The financial disclosures show that the clock is ticking on Evergrande. While its problems caused some contagion in July, Chinese property bonds have stabilized and have largely decoupled from Evergrande in August. Investors are increasingly realizing that Evergrande issues fall in the idiosyncratic rather than the systematic risk bucket.
Evergrande epitomizes the cardinal sins in debt investing of both poor financial governance and poor corporate governance. High leverage in and of itself would not have broken the back of Evergrande. There were also related-party transactions where the bank it controlled lent to related entities based less on merit than on relationship. Once one of Evergrande’s subsidiaries defaulted on a commercial bill, confidence eroded amongst stakeholders and led to a vicious downward cycle that is almost impossible to reverse, much like a bank run.
Is there such a thing as “too big to fail” in China?
Evergrande’s saga debunks the notion of “Too big to fail.” Size matters but in and of itself matters little. Size has to be coupled with strategic importance and interconnections with a country’s liquidity system. That means that “Too big and strategic to fail” does exists. It exists in China as it does in the rest of the world such as systematically important financial institutions like the largest banks in a country.
What should investors take away from the Evergrande saga? What do you do as a portfolio manager to mitigate the risks of investing in China?
Evergrande’s plight raises critical issues about investing anywhere in emerging markets, not just China. In addition to my previous point about corporate governance, it also underscores the importance of conducting thorough due diligence on the accounting, legal and regulatory regimes in bond investing:
- Accounting: What is cash, where does it sit and can I get my hands on it? Most Chinese issuers borrow from an offshore special purpose vehicle (SPV), a legal entity created to fulfil a specific, and often temporary, objective, which does not hold the assets. This means that it would be more difficult for foreign investors to attach assets, most of which are typically onshore.
- Legal: Structural subordination—understanding the nuances around seniority is critical. For example, one could argue that onshore shareholders are structurally senior to offshore bond holders because of the distance between the issuing entity of bonds and entities holding assets.
- Regulatory: Property is regulated at the central, provincial, and local level. For example, the government controls prices by putting a ceiling on property prices at the local level. Through curbs around mortgages, whether banks can lend to those holding several mortgage loans already, adjusting risk-weights around bank capital against mortgage loans, etc.
Do you see the current regulatory curbs continuing in China?
China has always marched to the beat of its own drum. China was the first to control COVID, and thus required the least policy easing to support its economy. Having seen its economy rebounding, China policymakers are no longer in crisis-fighting mode and are looking more to normalize their policies compared to policymakers in the rest of the world. We see anti-trust, consumer protection and privacy legislations curbing the powers of big internet platforms continuing, though we may be reaching “peak regulatory risk” as it is hard to imagine the pace of regulatory measures accelerating from the current unprecedented velocity.
And where do you see investment opportunities?
We see value in the convertible bonds of sectors hit by new China regulations. While these companies’ equities and convertible bonds have gotten hammered, the underlying credit story is intact. In fact, some of the convertible bonds are yielding higher than that of a plain vanilla bond of a same or similar credit AND the upside optionality of the underlying equity. It’s difficult to get that kind of positive skew in a bond portfolio so these convertibles are attractive both from a return as well as diversification and skew perspective.
Sectors like internet and health care have not been traditionally large borrowers so they can add diversification. Over the long term, we believe regulations in these sectors will improve treatment of labor and consumer safety, and limiting monopoly-like practices may well be positive. They may improve the sustainability of their business models by promoting healthy competition and improving consumer loyalty and sentiment.
Fixed income investments are subject to additional risks, including, but not limited to, interest rate, credit and inflation risks. Investing in emerging markets involves different and greater risks, as these countries are substantially smaller, less liquid and more volatile than securities markets in more developed markets. Securities denominated in a foreign currency are subject to the risk that the value of the foreign currency will increase or decrease against the value of the U.S. dollar.
All investments involve risk. Past performance is no guarantee of future results. Investing in Chinese securities involve risks. Heightened risks related to the regulatory environment and the potential actions by the Chinese government could negatively impact performance. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation.
As of June 30, 2021, portfolios managed by Matthews Asia did not hold: China Evergrande Group.