Period ended March 31, 2019
For the quarter ending March 31, 2019, the Matthews Asia Credit Opportunities Fund returned 6.04% (Investor Class), outperforming its benchmark, J.P. Morgan Asia Credit Index (JACI), which returned 4.89%.
After a challenging 2018, Asian credit markets rebounded meaningfully in the first quarter. After selling off for much of last year, Asian high yield credit spreads peaked at 622 basis points (6.22%) in early January. Since then, spreads have tightened steadily, ending the first quarter at 504 basis points (5.04%).
While the global economic cycle is advancing, policymakers and central bankers are, on the margin, becoming more accommodative. Much of the outperformance in Asian credit was driven by the increasing dovishness of the U.S. Federal Reserve, which reduced its expected rate hikes in 2019 from three to one. In addition, after a year of corporate deleveraging in 2018, China announced more measures meant to stimulate the economy, such as tax cuts and regulatory loosening, which improved sentiment in cyclical sectors. With many of the headwinds we saw in 2018 fading, including the trade war, a hawkish Fed and tightening Chinese financial conditions, markets are taking advantage of the respite.
Performance Contributors and Detractors:
During the quarter, the biggest contributor was the portfolio's overweight allocation to Asian high yield bonds, which as a group outperformed in the risk-on environment. Indonesian corporations, such as Modernland Overseas and Cikarang Listrindo, and Chinese property developers, such as KWG Group Holdings and CIFI Holdings Group, were top performers. Chinese property developers benefited as China announced measures to marginally loosen regulatory requirements for property sales as well as measures for general stimulus such as tax cuts. In addition, our positions in SoftBank Group perpetual bonds and Bharti Airtel were also contributors.
The biggest performance detractors to our relative performance against the Index were our underweight allocations in frontier Asian markets, such as Pakistan and Mongolia. By sector, our underweight to Macau's gaming industry was a detractor to Fund performance as the sector did well during the quarter. We remain underweight versus the benchmark in this sector, however, as we do not believe that current credit spreads adequately compensate investors for tail risks such as the potential for upcoming gaming license renewals given current U.S.—China trade negotiations. Frontier Asia, being high-beta sectors, rallied strongly with the market. In terms of absolute return, almost every bond in the portfolio had a positive return in the quarter, an indication of the strength of the rally.
Notable Portfolio Changes:
We made a number of changes to the portfolio in the first quarter, adding to corporate and sovereign holdings that we believed were positioned to rebound as the Asian credit market recovered. In corporates, we added select companies in Chinese property, such as CIFI Holdings Group and Shimao Property Holdings, due to better macroeconomic support for the sector and improvement in sentiment, and sold the convertible bonds of China Overseas Land & Investment as it reached our price target. We also increased our allocation to Indonesian corporates. We added the bonds of Indika Energy Capital after the company increased its stake in a well-run coal mine called Kideco on the Indonesian side of the island of Borneo. The transaction resulted in a company with a stronger balance sheet and better liquidity. Finally, we increased our overweight to Sri Lankan government bonds as we believe the country has been through the worst of its constitutional crisis and some political stabilization should soon manifest. Lastly, we increased the portfolio duration over the course of the quarter as we expect U.S. interest rates to be range bound for the coming quarters.
In our view, Asian high yield bonds offer attractive value for long-term investors. Asian high yield credit spreads are 50 basis points (0.5%) above their historic averages. Even after the recent tightening, Asia high yield spreads traded about 110 basis points (1.10%) 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 of the riskiest borrowers, refinancing has become easier in 2019 as investor risk appetite returned. We believe this continues to be a key risk to monitor and prefer to invest in names that have taken steps to refinance upcoming maturities or improved their balance sheets in other ways to be resilient to further turmoil.
We continue to see value in Chinese property, particularly given the magnitude of their sell-off last year. Policymakers are incrementally easing restriction on developers, pointing to an improving business environment in the second half of the year. We also see value in a number of sectors in Indonesia, including manufacturing and mining, and have been adding select companies such as Pan Brothers (PB International), a clothing manufacturer, and Indika Energy, a coal miner.
To be sure, there continue to be risks on the horizon. If a further slowdown in global growth materializes, we expect investor appetite for emerging markets to diminish. Any escalation in trade shocks could also put pressure on Asian fixed income markets. If the Chinese economy deteriorates, corporate defaults will likely rise, and Asian credit could come under pressure. However, our base case remains a benign one, with most of the key global macro tail risks fading. We believe the U.S. should continue to see solid, albeit lower, positive economic growth. A hard Brexit outcome has been legislatively put to bed, though a long and uncertain path will cause the UK to muddle along. European politics will likely result in more populist policies regardless of whether the left of the right wins the upcoming European elections. Last but not least, we see China's economic growth bottoming during the first half of this year, with sentiment already starting to rebound.
As of 3/31/2019, the securities mentioned comprised the Matthews Asia Credit Opportunities Fund in the following percentages: SoftBank Group Corp., 6.000%, 07/19/2049 3.6%; KWG Group Holdings, Ltd., 6.000%, 09/15/2022 3.6%; KWG Group Holdings, Ltd., 5.875%, 11/10/2024 0.7%; Socialist Republic of Vietnam, 5.500%, 03/12/2028 2.7%; Socialist Republic of Vietnam, 4.800%, 11/19/2024 0.8%; Modernland Overseas Pte, Ltd., 6.950%, 04/13/2024 2.6%; Bharti Airtel, Ltd., 4.375%, 06/10/2025 2.1%; CIFI Holdings Group Co., Ltd., 6.875%, 04/23/2021 2.0%; CIFI Holdings Group Co., Ltd., 5.500%, 01/23/2023 1.1%; CIFI Holdings Group Co., Ltd., 5.500%, 01/23/2022 0.8%; Listrindo Capital BV, 4.950%, 09/14/2026 1.9%; Sri Lanka Government Bond, 6.125%, 06/03/2025 1.7%; Sri Lanka Government Bond, 6.850%, 11/03/2025 1.3%; Shimao Property Holdings, Ltd., 4.750%, 07/03/2022 1.5%; Shimao Property Holdings, Ltd., 5.200%, 01/30/2025 1.5%; Indika Energy Capital III Pte, Ltd., 5.875%, 11/09/2024 1.3%; PB International BV, 7.625%, 01/26/2022 4.2%. The Fund held no positions in China Overseas Land & Investment convertible bonds. Current and future portfolio holdings are subject to risk.