Period ended December 31, 2018
For the year ending December 31, 2018, the Matthews Asia Credit Opportunities Fund returned -2.88% (Investor Class), while its benchmark, the J.P. Morgan Asia Credit Index, returned -0.77% over the same period. For the fourth quarter, the Fund returned -0.68% (Investor Class), while its benchmark returned 0.65% over the same period.
2018 was notable as the impact of strong growth in the U.S. and macroeconomic headwinds in China led to tighter financial conditions and wider credit spreads across Asia. The U.S. economy decoupled from the rest of the world as U.S. growth strengthened despite softness in other regions. The U.S. Federal Reserve raised interest rates four times and continued the balance sheet reduction it started in 2017. With a divergence in growth and tighter policy in the U.S., volatility in emerging market asset classes around the world was higher in 2018.
Asia's credit markets were not immune to tighter financial conditions and higher volatility in 2018. High yield spreads in Asia widened 169 basis points (1.69%) in 2018 from 437 basis points (4.37%) to 606 basis points (6.06%) above U.S. Treasuries. Trade tensions between the U.S. and China, as well as the Chinese government's deleveraging campaign, led to weaker sentiment. Amid this backdrop, the new issue market was noticeably quieter, with many high yield deals done with a one- to three-year maturity, rather than the more typical three to five years. The most challenged Asian markets included Indonesia, where weakness in the rupiah led to a repricing of U.S. dollar-denominated corporate bonds, and Sri Lanka, where political turmoil led to uncertainty.
Performance Contributors and Detractors:
In 2018, among the biggest contributors to portfolio returns were our holdings in the bonds of Bangkok Dusit Medical Services, Socialist Republic of Vietnam and Pan Brothers International (PB International). Bangkok Dusit Medical is a hospital operator in Thailand. With Bangkok Dusit Medical's improving results and guidance, its convertible bonds performed well as the underlying equity rallied. We exited the holding in June as we reached our price target. Socialist Republic of Vietnam bonds are Brady bonds issued in 1998. With part of the principal secured by U.S. Treasuries and the ongoing amortization of principal, the bonds earn an attractive coupon with minimal price volatility. Pan Brothers International is a high-quality Indonesian garment manufacturer in Indonesia.
Among the largest detractors to Fund performance in 2018 were our holdings in Lippo Karawaci (Theta Capital Pte.), Modernland and Softbank. Lippo Karawaci and Modernland are property developers in Indonesia. Lippo Karawaci bonds were downgraded by ratings agencies based on the company's limited liquidity without executing asset sales. Modernland bonds fell on weakness in the Indonesian rupiah and continued softness in Jakarta's property market. Softbank bonds weakened as investor skepticism of its portfolio of high tech investments rose with the rising volatility of the Nasdaq.
Notable Portfolio Changes:
We made a number of changes to the portfolio in the fourth quarter, adding high quality credits across the region while exiting two credits in Indonesia and China. We added a handful of U.S. dollar-denominated bonds that we believe have attractive yields relative to the risk we are taking. For instance, we initiated a position in China Minmetals, a state-owned enterprise with minimal default risk and attractive upside from our expectation that the company will call the bonds at a higher price. We also added the bonds of Pan Brothers International. Its expertise in performance fabrics along with its strong financials and solid management team are an attractive combination. We also added the bonds of Bharti Airtel, an Indian telecom operator. The bonds are pricing in a downgrade from investment grade to high yield, but we believe many of Bharti's challenges are behind it.
We sold the bonds of Lippo Karawaci and the convertible bonds of China Railway Construction. In 2018, Lippo Karawaci, an Indonesian property developer, announced asset sales to help recapitalize its balance sheet, but we believe it will take several years for the company to complete its targeted divestments and normalize operations. We also exited the convertible bonds of China Railway Construction. As the underlying equity rallied, our bonds performed well and reached our price target.
In our view, Asian high yield bonds offer attractive value for the long-term investor. Asian high yield credit spreads are 150 basis points (1.5%) above their historic averages, and this is the first time in several years that Asian spreads have reached a level one standard deviation above their historic averages. In contrast, spreads for U.S. high yield spreads are 20 basis points (0.2%) below average and European high yield spreads are 80 basis points (0.8%) below average. In simple terms, Asian high yield bonds are compensating investors for taking credit risk even with continued volatility.
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 or further outflows stemming from policy normalization in the U.S. 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. Indeed, we see much of this scenario already factored into current valuations as trailing 12-month default rates are hovering at only 1% per annum. Based on our solvency and liquidity analysis, we do not expect any of the securities in the portfolio to default. As such, the relatively attractive yields in Asia offer a strong base for positive returns in 2019.
As of 12/31/2018, the securities mentioned comprised the Matthews Asia Credit Opportunities Fund in the following percentages: Socialist Republic of Vietnam, 5.500%, 03/12/2028 3.6%; Socialist Republic of Vietnam, 4.800%, 11/19/2024 1.0%; China Minmetals Corp., 3.750%, 05/13/2067 1.8%; PB International BV, 7.625%, 01/26/2022 2.9%; Bharti Airtel, Ltd., 4.375%, 06/10/2025 1.9%; Modernland Overseas Pte, Ltd., 6.950%, 04/13/2024 2.9% and SoftBank Group Corp., 6.000%, 07/19/2049 4.2%. The Fund held no positions in (Lippo Karawaci) Theta Capital Pte, Ltd.; Bangkok Dusit Medical Services Public Co., Ltd. or China Railway Construction Corp., Ltd. Current and future portfolio holdings are subject to risk.