Period ended September 30, 2019
For the quarter ending Sept. 30, 2019, the Matthews Asia Credit Opportunities Fund returned 1.43% (Investor Class), while its benchmark, the J.P. Morgan Asia Credit Index (JACI), returned 1.89%.
Asian credit markets were positive in the third quarter, with falling interest rates in the U.S. driving performance. Investment grade credit performed particularly well given its higher sensitivity to interest rates and tendency to act as a safe haven for investors in times of volatility. In fact, in the third quarter, credit spreads for Asian investment grade bonds were flat, while Asian high yield spreads widened 45 basis points (0.45%).
Markets spent much of July looking ahead to the U.S. Federal Reserve's meeting on July 31, which delivered the Fed's first rate cut in over a decade. The so-called insurance cut showed the Fed's agility in responding to softer economic data midcycle, despite an almost ideal environment of low inflation and unemployment. This was quickly overshadowed by President Trump's August 1 Twitter announcement, however, that the U.S. would raise the stakes in its trade war with China by imposing 10% tariffs on another US$300 billion of Chinese goods.
Investors' fears of a tariff shock to the global economy came back to the forefront. The ensuing risk-off environment led to a sharp rally in U.S. interest rates, with the 10-year Treasury yield falling by over 50 basis points (0.5%) in August. As investors reduced risk, high yield credit spreads widened, eroding much of the benefit from falling interest rates. While macro and political headlines accounted for most of the volatility in Asian credit markets in the quarter, default rates remained relatively low in the region.
Performance Contributors and Detractors:
During the third quarter, the biggest contributors to performance were the portfolio's allocation to quasi-sovereigns. Companies such as PLN and Inalum in Indonesia, Debt and Asset Trading in Vietnam, and China Jinmao (Franshion Brilliant) were top contributors as higher-quality credit outperformed. PLN and Inalum bonds are long-dated and, because of their high duration, benefited from the fall in the long end of the U.S. interest rate curve. Debt and Asset Trading is a wholly owned entity of Vietnam's Ministry of Finance and benefits from its sovereign ownership, while Jinmao is a subsidiary of state-owned Sinochem Group. As higher-quality credit outperformed lower-quality credit in the quarter, these companies contributed significantly to the portfolio's performance.
The biggest detractors to performance were our positions in Modernland, SoftBank and Pakistan sovereign bonds. Modernland is an Indonesia property developer, and because of its small size it tends to be a higher beta holding in the portfolio. SoftBank's underperformance can be attributed to negative headlines about WeWork, which SoftBank holds both directly and in its Vision Fund. While the market will follow negative news from the Vision Fund, we focus on the fact that the SoftBank holding company has other significant assets, such as a 26% stake in Alibaba and the anticipated sale of Sprint. As such, we think the market is pricing in high credit risks relative to SoftBank's ability to monetize assets and repay creditors.
Notable Portfolio Changes:
With the portfolio already positioned to weather increasing trade tensions, we made only a handful of changes in the quarter. We exited our positions in the bonds of Sprint Communications and Sriram Transport Finance. Sprint bonds reached our price target after the chairman of the U.S. Federal Communications Commission recommended approval of its merger with T-Mobile and we chose to lock in our gains. While Shriram Transport continues to be a strong operator in the non-bank financial sector in India, many of its peers are coming under funding stress. We chose to take profits rather than risk any downside brought on by industry pressures.
We also added the convertible bonds of Luye Pharma. The pharmaceuticals industry in China has come under increased regulatory scrutiny, but we think the impact on Luye is likely to be limited. We believed Luye's convertible bonds were oversold, giving us an attractive entry point. We also added to a number of existing holdings in the portfolio as spreads widened, particularly in China and Indonesia. We continue to focus on higher-quality companies that we think have strong balance sheets, solid free cash flows and management teams that we believe can navigate an economic downturn.
In our view, Asian high yield bonds continue to offer attractive value for long-term investors. Asian high yield credit spreads are 130 basis points (1.30%) above their historic averages and are about 183 basis points (1.83%) above U.S. high yield spreads at the index level. We think there is room for this relationship to tighten back closer to historical levels. Default rates in Asia have remained low and we believe could stay low in the medium term as interest costs and recession risks remain low. For many higher-risk borrowers, refinancing has been easier in 2019 as investor risk appetite has returned. In fact, high yield issuance in the first nine months set a new record and was up almost 80% versus 2018. We believe this is a key risk to monitor, and we prefer to invest in holdings that have taken steps to refinance upcoming maturities or improve their balance sheets in other ways to be resilient to further turmoil.
We continue to see value in Chinese property, particularly in what we view as the highest-quality developers, given the magnitude of the sell-off and the incremental easing of restrictions on developers. We also see value in a number of sectors in Indonesia, including manufacturing and mining. With the momentum among developed and emerging market central banks shifting toward synchronized easing, we expect domestic business environments in Asia to be supportive in an environment of slowing global growth and trade.
To be sure, risks remain on the horizon. If a further slowdown in global growth materializes, we expect investor appetite for emerging markets to diminish. Any further trade shocks could also pressure Asian fixed income markets. If the Chinese economy deteriorates, corporate defaults will likely rise, and Asian credit could come under pressure. Our base case, however, remains benign, with most of the key global macro tail risks fading, supportive central banks and Chinese economic growth set to rebound.
As of 9/30/2019, the securities mentioned comprised the Matthews Asia Credit Opportunities Fund in the following percentages: PT Perusahaan Listrik Negara, 5.250%, 05/15/2047 3.8%; PT Indonesia Asahan Aluminum Perser, 6.757%, 11/15/2048 3.9%; Debt and Asset Trading Corp., 1.000%, 10/10/2025 4.7%; Franshion Brilliant, Ltd., 5.750%, 07/17/2067 5.0%; Modernland Overseas Pte, Ltd., 6.950%, 04/13/2024 2.1%; SoftBank Group Corp., 6.000%, 07/19/2049 4.5%; Pakistan Government Bond, 6.875%, 12/05/2027 4.0%; Luye Pharma Group, Ltd., Cnv., 1.500%, 07/09/2024 1.9%. The Fund held no positions in Shriram Transport Finance Co., Ltd.; Sinochem Group; Alibaba Group Holding, Ltd.; We Co. (WeWork); SoftBank Vision Fund (a holding company of SoftBank Group Corp.); Sprint Communications, Inc.; or T-Mobile (Deutsche Telekom AG). Current and future portfolio holdings are subject to risk.