Period ended June 30, 2019
For the first half of 2019, the Matthews Asia Strategic Income Fund returned 8.39% (Investor Class), while its benchmark, the Markit iBoxx Asian Local Bond Index, returned 5.27%. For the quarter ending June 30, the Fund returned 2.56% (Investor Class) compared to the benchmark return of 2.11% over the same period.
The combination of supportive central banks and positive trade news led to a constructive environment for Asian fixed income over the second quarter, with Asian credit, currencies and rates all performing positively. The U.S. Federal Reserve, the European Central Bank and emerging market central banks all moved in a dovish direction during the quarter, seemingly ending the momentum for higher rates around the world. Meanwhile, the G-20 Summit ended without an escalation in the U.S.—China trade war, at least temporarily removing the risk of a further tariff shock from the global economy.
While the quarter was positive overall, geopolitics led to unexpected volatility. The quarter began with a positive tone as data from the U.S. and China implied that fears of a synchronized growth slowdown may have been overdone. Optimism evaporated in early May, however, when President Trump threatened to raise tariffs on all Chinese imports, including consumer-related goods, and attempted to limit U.S. companies from doing business with Chinese tech giant Huawei. By the end of May, equities markets had relinquished most of their year-to-date gains.
For Asia credit, this caused high-yield spreads to widen by about 40 basis points during May and 35 basis points over the quarter. The rally in U.S. rates more than offset this modest spread widening, so total return from credit bonds was positive for the quarter.
Asian local rates generally followed U.S. rates lower over the quarter, albeit to a lesser degree. Asia currency returns were mixed, with some currencies such as the Thai baht, the Philippine peso and the Indonesian rupiah outperforming the U.S. dollar, while others, notably the Chinese renminbi, the Korean won, and the Malaysian ringgit underperforming the U.S. dollar.
Performance Contributors and Detractors:
During the first half and the second quarter, the biggest contributor to Fund performance was the portfolio's overweight in Asian USD high-yield corporate bonds, which delivered positive performance. Within high-yield corporate bonds, the strongest contributors over the quarter included PT Perusahaan Listrik Negara, a government-owned Indonesian utility, Tata Steel (ABJA Investment Co.) and Indika Energy Capital III bonds. Our exposures to convertible bonds, including CP Foods Holdings, Weibo and Zhongsheng Group Holdings, also contributed strongly within corporate exposures. In addition, our exposure to the Vietnam government-backed Debt & Asset Trading Corp. contributed to outperformance.
The biggest detractors to our performance were our currency forward positions in the Korean won and the Chinese renminbi (RMB), both currencies that underperformed the U.S. dollar over the quarter. Other detractors to performance included our convertible bond position in Ctrip.com International, Ltd., a Chinese online travel agency, as well as our holding in the RMB-denominated bonds of China Jinmao (Franshion Brilliant), a Chinese property developer.
Notable Portfolio Changes:
We made a number of changes to the portfolio in the second quarter, rotating out of shorter-duration bonds and bonds with higher equity beta, and adding longer-duration bonds and issues with asymmetric risk profiles.
Within corporate bonds, we initiated positions in two Indian issuers: Shriram Transport Finance, an Indian non-bank finance company that issued a U.S.-dollar bond with an attractive spread premium given the recent non-banking financial companies sector (NBFC) funding crisis; and Tata Steel (ABJA Investment), one of the world's largest steel producers, where we gained exposure through a long-duration issue. We also initiated positions in two Chinese issuers: Logan Property Holdings, a top 20 developer that offered an attractive spread premium given its exposure to China's Greater Bay Area, and to the technology firm Weibo via convertible bonds that were trading close to their lowest possible level, and which we saw as offering an asymmetric risk profile.
We increased overall duration in the portfolio to 4.5 years from 3.7 years by rotating out of short-duration bonds, including Aluminum Corporation of China (Chinalco Capital Holdings), Olam International and Krung Thai Bank Public, and also by adding longer-duration exposures. We also exited two bond holdings: Huaneng Hong Kong Capital and China Minmetals. Despite being perpetual bonds, they did not offer material duration due to the embedded fixed-to-floating coupon resets.
Outside of corporate bonds, we added to Indian duration via interest-rate swaps to take advantage of lower-than-expected growth and inflation in the country, which we expect to bring about rate cuts. We also added Malaysian government bond exposure given the country's weak economy, attractive carry profile and as we believe the current market is underpricing the likelihood of rate cuts.
Finally on currency, we increased exposure to the U.S. dollar by cutting exposure to most Asian local currencies, with the Indian rupee and Malaysian ringgit being notable exceptions.
The U.S. and global economies both look to be late cycle, characterized by falling inflation and moderating GDP growth. Fed funds futures are pricing in two interest rate cuts by the Fed before the end of this year. Despite lackluster growth in the U.S., its equities continue to rally.
How is it possible that the bond markets are pricing such negativity while equities are so bullish? Our best explanation for this is that equity markets are pricing in perfect execution by the Fed. In other words, equities are expecting the Fed and other central banks to deliver sufficient rate cuts and loosen monetary policies to extend the current expansion.
Because few Asia government bond curves have fully priced in the dovish G-3 central banks, we maintain a long exposure to interest rate duration in Asia, where the bond markets have more room to rally. We expect that over the coming quarters, Asian central banks will become increasingly dovish, with their respective yield curves falling to price in more rate cuts. This means that even those central banks that may have been reluctant to cut should likely follow suit. We place the more-developed, lower-yielding countries like Thailand, South Korea and Malaysia solidly in that camp. Even the emerging Asian economies of India and Indonesia will have more room to cut rates given subdued domestic inflation.
Given our outlook, the biggest risk is that the equities markets are wrong. This would mean potential credit spread widening. However, in our base case, lower rates globally bodes well for credit spreads to remain stable.
As of 6/30/2019, the securities mentioned comprised the Matthews Asia Strategic Income Fund in the following percentages: PT Perusahaan Listrik Negara, 5.250%, 05/15/2047 2.5%; Tata Steel (ABJA Investment Co. Pte, Ltd.), 5.450%, 01/24/2028 3.7%; Indika Energy Capital III Pte, Ltd., 5.875%, 11/09/2024 2.8%; CP Foods Holdings, Ltd., Cnv., 0.500%, 09/22/2021 3.1%; Weibo Corp., Cnv., 1.250%, 11/15/2022 2.0%; Debt and Asset Trading Corp., 1.000%, 10/10/2025 4.6%; Shriram Transport Finance Co., Ltd., 5.700%, 02/27/2022 3.9%; Logan Property Holdings Co., Ltd., 5.250%, 02/23/2023 2.5%; China Jinmao (Franshion Brilliant, Ltd., 5.750%, 07/17/2067) 2.8%; China Huaneng Group Co., Ltd., 3.950%, 04/21/2026 2.5%; Malaysia Government Bond 4.642% 11/07/2033 2.1%. The Fund held no positions in Zhongsheng Group Holdings, Ltd.; Ctrip.com International, Ltd.; Aluminium Corporation of China (Chinalco Capital Holdings, Ltd.); Olam International, Ltd.; Krung Thai Bank Public Co., Ltd; China Minmetals Corp. Current and future portfolio holdings are subject to risk.