Period ended March 31, 2020
For the quarter ending March 31, 2020, the Matthews Asia Credit Opportunities Fund returned -12.73% (Investor Class) while its benchmark, the J.P. Morgan Asia Credit Index, returned -3.60%.
2020 started on a seemingly good note, with the U.S. and China signing Phase 1 of the trade deal on January 15th. Shortly thereafter, though, China locked down the city of Wuhan to try to slow the spread of the novel coronavirus. The virus would soon spread through Asia and across the world, leaving public health officials, policymakers and central banks scrambling to react to both the health care and economic challenges that treatment and containment presented. Despite the fact that China was the epicenter of the outbreak, Asian high yield credit spreads remained steady in the 500-550 basis point (5.00-5.50%) range until late February. As the coronavirus spread through the U.S. and Europe, fixed income, equity and commodity markets around the world came under pressure. In Asia, high yield credit spreads nearly doubled in a one month period from late February to late March, peaking at 1,040 basis points (10.40%) on March 23, before recovering into month end.
Many countries around the world have aggressively pursued containment policies, and policymakers have responded to the sudden halt in economic activity with bold fiscal and monetary measures. The U.S. Federal Reserve has committed to using its tools to steady a variety of markets, including Treasuries, investment grade corporates, mortgages and municipal bonds. Asian policymakers have responded aggressively, particularly in China, where banks have been asked to roll over loans rather than force companies to repay or refinance their debt. Our exposure across the portfolio to companies driven by domestic consumption and services has provided some insulation relative to companies in industries more exposed to foreign demand.
Another key contributor to the drastic fall in price of credit has to do with the embedded optionality of the bonds. Because most high yield bonds have an embedded option that enables issuers to call or reset their debt, much of the price depreciation has to do with credit duration extension. As credit risks rose, securities extended in credit duration from trading to the next call/reset date to trading to their maturity date, necessitating a step down in the price of their bonds in order to offer not only a higher spread, but also to a longer maturity date.
Performance Contributors and Detractors:
During the first quarter, amongst the biggest detractors to Fund performance were our holdings in the frontier sovereigns of Sri Lanka and Pakistan, and Indika Energy in Indonesia. Frontier sovereigns like Sri Lanka and Pakistan are usually more exposed to external shocks than developed and emerging countries, and policymakers have more limited scope to provide fiscal and monetary support to their domestic economies. Because of this, the coronavirus slowdown hit the sovereign bonds of Sri Lanka and Pakistan particularly hard. Indonesian credits, including the coal mining company Indika Energy, were hit hard during the sell-off. Indika suffered both because of the general risk-off environment and the fall in commodity prices.
On the other hand, our holdings in the bonds of iQIYI and Sino Ocean in China and Debt and Asset Trading in Vietnam were amongst the biggest contributors to Fund performance. The convertible bonds of iQIYI, an online entertainment service in China, performed well as the underlying shares rallied on expectations for robust subscriber growth during China's lockdown. Sino Ocean is a state-owned property developer in China, and its perpetual bonds performed well despite the market volatility. Debt and Asset Trading Corp. is a wholly-owned subsidiary of Vietnam's Ministry of Finance, and their bonds provide an attractive spread pickup to sovereign bonds.
Notable Portfolio Changes:
We made a handful of changes to the portfolio in the first quarter. We added the convertible bonds of Bosideng Group, a down jacket brand in China, and the perpetual bonds of Jollibee Worldwide, a restaurant chain in the Philippines. We expect both bonds to perform well once the current crisis subsides and economic activity normalizes. We also added to existing holdings across the region, including in high-quality Chinese property companies like CIFI Holdings, Franshion Brilliant and KWG.
We exited the convertible bonds of iQIYI, an online video platform in China, after they reached our price target.
At the current implied default rates of mid-teens, we believe there is significant value in Asian credits that will weather the storm and avoid defaulting. As of March 31, 2020, Asia high yield spreads are at 958 basis points (9.58%). At the peak of the global financial crisis in the fourth quarter of 2008, Asia high yield spreads widened to about 1, 000 basis points (10.0%). Assuming historical recoveries of 45 cents on the dollar, current spreads are impounding about 15% probability of default already. With rolling 12 month default rates at 2.43% as of March 31, 2020 and a portfolio of credits which we do not believe will default, we believe that current prices could represent a once in a decade entry point.
One of the most vulnerable segments is the frontier sovereigns, which have rolling maturities that need a functioning capital market to refinance, including countries like Pakistan and Sri Lanka. Fortunately, Pakistan has already secured financing from multilateral lenders to cover maturities for the next few years. Sri Lanka has announced additional financing from China and its resolve to honor its debt obligations.
We continue to assess relative value across credits in an effort to lock in attractive yields while seeking to upgrade the portfolio. As credit spreads stabilize and recover, we believe our bonds will appreciate in price from the shortening of credit duration. We expect that this will reverse the credit duration extension that impacted all high yield debt previously described. As Asian economies recover from trough economic activity, we believe that our portfolio has significant positive skew and upside returns potential. While past performance is not indicative of future results, history has shown that any one year period can have outsized returns, both positive and negative. Asia high yield experienced a drawdown of -25% during the global financial crisis, but also gained 54% in the year following the crisis.
As of 3/31/2020, the securities mentioned comprised the Matthews Asia Credit Opportunities Fund in the following percentages: Pakistan Government Bond, 6.875%, 12/05/2027, 4.4%; Sri Lanka Government Bond, 7.850%, 03/14/2029, 1.8%; Sri Lanka Government Bond, 6.125%, 06/03/2025, 0.6%; Sri Lanka Government Bond, 6.850%, 11/03/2025, 0.6%; Sri Lanka Government Bond, 6.825%, 07/18/2026, 0.2%; Indika Energy Capital III Pte, Ltd., 5.875%, 11/09/2024, 3.7%; Sino-Ocean Land Treasure III, Ltd., 4.900%, 03/21/2068, 5.6%; Viet Nam Debt & Asset Trading Corp., 1.000%, 10/10/2025, 4.9%; Bosideng International Holdings, Ltd., Cnv., 1.000%, 12/17/2024, 4.0%; Jollibee Worldwide Pte, Ltd., 3.900%, 07/23/2068, 1.4%; CIFI Holdings Group Co., Ltd., 6.550%, 03/28/2024, 2.7%; CIFI Holdings Group Co., Ltd., 5.375%, 02/24/2068, 1.9%; Franshion Brilliant, Ltd., 5.750%, 07/17/2067, 5.1%; KWG Group Holdings, Ltd., 5.875%, 11/10/2024, 3.1% KWG Group Holdings, Ltd., 7.875%, 09/01/2023, 1.3%; KWG Group Holdings, Ltd., 7.400%, 03/05/2024, 0.3%. The Fund held no positions in iQIYI, Inc., Cnv., 2.000%, 04/01/2025. Current and future portfolio holdings are subject to change and risk.