Stewart: EM Asia, a very interesting market from a risk return perspective, particularly given today's prevailing interest rate environment. My name's Stewart Foley. This is the insurance AUM journal podcast. And we're joined today by Sheldon Chan of T. Rowe Price. Sheldon is a portfolio manager of the Asia credit bond strategy and the fixed income division. You're located in Hong Kong. You've been at this awhile. Your career started way back in 2004. You're a product of Cambridge university and you stayed up late to be here, Sheldon, thanks for being on.
Sheldon: Hi Stewart, I hope you're doing well as well. Thanks very much for having me on.
Stewart: You are in Hong Kong. It is very early in the Midwest and very late there. So thank you for taking the time. A lot of people are talking about EM in this current rate environment, your specialty is Asia. Can you give us a backdrop of your view of that market in this rate environment in general to start?
Sheldon: Yeah, sure. So the incentive to move into yield enhancing asset classes such as emerging markets is definitely going to be there. I think within that, for me, I do feel Asia credit is a fairly compelling story. I think you do have more defensive and higher quality segment of the market, a good place for investors to start on that journey into emerging markets. So right now, if you think about Asia credit, the Asia credit universe, right now the average yield available is up three percent. At the same time, you can also get that with less duration risk than most developed market fixed income products as well. And so on the back of that, we have started seeing an increase in engagements with U.S. insurance companies. They are obviously looking to enhance yield. We did recently start to partner with one insurer to create a customized yield oriented investment grade portfolio. And for that one, I think Asia credit was a key part of the portfolio construction for some of the reasons that I touched on.
Stewart: And no discussion of any sort of investment these days goes without a discussion of ESG, right. We've done a number of podcasts on ESG. Could you talk a little bit about Asian corporate and sovereign sectors as far as governance goes? Is it weaker for example?
Sheldon: Yeah, sure. So I think when it comes to governance and ESG challenges, I think trying to navigate some of those, that's pretty much par for the course, when you're talking about investing in Asia and more broadly in the EM disclosure, that is certainly one issue. I do think what we find is that there is a wide variance in standards across different countries and across different companies. And for sure there are going to be some where you will see disclosures much weaker then what we're going to be used to develop markets in the USA. But I think also on top of that, another key issue is knowing the key shareholders and the key actors behind the different issuers. A lot of the time, those are the sponsors and they really can drive the credit narrative. One of the more unique factors within Asia: most companies almost or most issuers that come into the market.
Sheldon: They have a typical ownership structure. That's going to be dominated either by one, a government and state ownership or two, a founding family and with a chairman or chairperson that continues very much to call the shots as part of corporate management. I remember the story, in this case, there was a company chairman. He was getting grilled by investors because the company was making certain investments. And so the investors in the room were saying, “Why are you doing this? This is really good for the company strategy.” And he started to get a bit fed up towards the end and he announced to the room that it's his company, his money, he's going to choose what he wants to do with it. So that's areas where you want a bit of warning signs when as a creditor and a bond holder, you feel your incentives with the management aren't so much aligned.
Sheldon: So the story about obviously traditional credit analysis of looking at balance sheets and profit margins, that alone probably doesn't tell you everything you need to know in our space. So instead of having a lot of the local knowledge and having local insights helps. So what we find in Asia at T. Rowe is that we do get a lot of good perspectives from our equity colleagues, because what happens as well is a lot of issuers that come to print and come to the primary markets and fixed income, they often do so having earlier done equity roadshows and listed in IPO first. So the track record within that market tends to be longer.
Sheldon: You touched on sovereigns: I think definitely political regulatory risk. That's another key factor, EM election cycles. You know, often we do have to follow those closely because there will be some implications on policy and policy direction, but again, probably where Asia stands out a bit more versus the rest of EM politics tends to be more stable. And also that the implementation of macro economic policies is pretty well institutionalized. So we don't see things..the stability tends to be there.
Sheldon: And then just to round out the ESG discussion, we talked a lot about governance, but environmental issues definitely have gotten a lot more attention in the last couple of years. Asia does screen as particularly reliant on fossil fuels. I think that we have a statistic where if you look at all the fixed income benchmarks globally, Asia credit actually has the highest carbon footprint per dollar of revenue. And that's from countries such as India and Indonesia still having very carbon intensive power generation systems. They’re still fairly reliant on coal, which for all the environmental negatives, it's cheap and abundant and it's allowed those economies to get electrified. So in all of these senses, Asia is still very much an emerging region, but naturally as the markets become more mature, better institutional frameworks, I think disclosures will get better. So I like to think of it also as an opportunity for improvement. So getting invested now, and you hopefully get the upside of some future compression and the spread and risk premiums.
Stewart: That's a great overview. So let me look at something a little more specific. I often say to people that the person who learns the most out of these podcasts is me and this one's particularly of interest. Chinese property sector. Is that sector creating concentration risk in the asset class?
Sheldon: Yeah, it's definitely a very important sector within your opportunity set. It's been growing fast over the past 10, 15 years. There's now about 70 Chinese developers within the entire opportunity set. It's about 12% of the outstanding bottom stock. So it's definitely meaningful. And historically a lot of these are high yield names. So they offer attractive yields, low duration as well. And you know, if you've been invested in it, you've been able to get pretty strong, positive returns over the years in this sector. Right now, there is, justified, there is a fair amount of focus on the industry because I think we are facing some headwinds of tightening domestic policy. The Chinese government has a long stated mantra: Housing should be for living and not for speculating. And so we saw China's economic recovery from COVID started to firm up well in the second half of last year.
Sheldon: And then we saw as a response, the domestic policy tighten up particularly for the housing sector. We've had a number of different policies come into place, capping bank exposure to developer loans, capping mortgages, you have targeted purchase restrictions in some cities as well, and also quotes as for bond issuance. A lot of these are really just a place, more regulatory oversight on access to funding. And you might've heard this one, this policy has had quite a bit of airtime. It's known as “the three red lines:, a nice sort of catchy summary. Basically developers have to watch three specific credit ratios and they have to over time improve that balance sheets to make sure that within the guidelines that the government is setting for them. I actually think this will be healthy in the long term because developers will have to be more prudent, they're going to have to pare back some of their debt and their leverage, but in the near term, that will be some volatility.
Sheldon: Some of these developers are going to find themselves unable to access the funding that they need. They may run into refinancing pressure, and you could even see some defaults start to emerge as well. So right now, from a shorter term, nearer term view, I think it makes sense to have a diversified portfolio and to look and to get some of your yield exposure from other countries and industries as well. But it's definitely not all bad. I think likely in any industry you're going to have winners and losers. So having that toolkit to select the credits is going to be pretty important. You step on a landmine and you'll have downgrades, you'll have impairments, but if you pick a winner, not only can you get some of the attractive yields that are there, but also the upside in capital appreciation.
Sheldon: For example, if I look back to last year, a couple of the best performing names within the entire opportunity set were actually China real estate developers that had originally come to market as high yield credits. But the track record with the one holds the community and actually got upgraded into rising stars in it's an investment grade over the course of 2020. So definitely some positive opportunities to look out for.
Stewart: It's interesting. You said at the very beginning of your answer that you've got some yield without a lot of duration and as you well know, insurance companies have been extending for a long period of time to capture the additional yield of an upwardly sloping yield curve. And as rates have backed up rather aggressively, I think a lot of people have said, wow, there's a huge impact there. So it's interesting that you bring up the duration component of the asset class as well. So here's a big question that is impossible to answer: how about the impact of political tensions between the US and China? That relationship has been changing to say the least. What's your view there?
Sheldon: Yeah, it sounds like we've definitely warmed up into the tricky ones now.
Stewart: Yeah, there you go. The easy ones are over Sheldon. Now it gets difficult!
Sheldon: No, no. As you say, I think it's an important topic. It's going to remain pretty high up on the agenda. I think the markets have had to deal with it for some time since the last administration with the trade war and a lot of other verbal jousting that's gone on between the two groups over the years. it's been a source of volatility, is going to clearly be something we're going to have to continue dealing with for the foreseeable future as well. My thing on the one hand that that bipartisan support in the U.S. for a “tough on China'' policy. So far, very few signs that the current administration is going to take a soft turn on that. But on the other hand, China is still a very much a large player, very deeply integrated in the global economy. So there's going to be areas where you'll need to have that cooperation, even if there's going to be that element of strategic competition going forward.
Sheldon: So, so many branches, let me boil it down to a couple of things. I think where I think the U.S.- China story has really impacted our asset class. So the first is on sanctions. Sanctions from the U.S., specifically, there were these investment restrictions that came and were initiated by the outgoing President Trump administration. So last year we had the Pentagon name a bunch of companies as Chinese communist military companies on account of them being controlled by the Chinese People's Liberation Army. And then in the fall that was followed up in November when the president had issued this executive order, basically banning U.S. investors from owning and trading securities in these names, there's about forty-three companies on this, and by our estimate, that impacts up to 90 billion us dollars. That would be about nine percent of our Asian dollar bond opportunity set, so not an insignificant amount.
Sheldon: I think a couple of things I should make clear. Firstly, there isn't a material fundamental impact on these issues. Most of them have very little if any business in the US and they will all have ample funding channels in China domestically as well, but trying to transact some of these securities and sell them in markets when the trading liquidity can be poor can be fairly one sided that has and continues to lead to some fairly volatile swings and spreads. And I think we're still very much watching as to how that list develops. So we're going to have more names added or not. So it's still an area of uncertainty. The second implication is tied to the risk policy response from China. So I touched on this a little bit with the property sector, but the competitive tension with the U.S has led the Chinese leadership to shore up resilience and lots of key areas, including trade technology, manufacturing, but particularly the domestic financial system.
Sheldon: They really want to double down on that commitment to reduce risks and reduce leverage within the financial system. For instance, we saw China was one of the earliest to pair back credit growth in the second half of 2020 as the economy kind of got back on its feet. And so not only has it impacted the real estate sector, but it's also fed through to state-owned enterprises. You've heard a lot about SOE reform over the years and trying to get rid of the zombie companies where zombies aren't really that productive. But it's impacted our space where you've had names that have previously traded on this assumption of implied government support. SOEs because our sovereign state can be a fairly significant part of credit markets because that government ownership is typically seen as the positive and that a lot of these have been able to raise a large amount of debt and bonds into the market because of that factor.
Sheldon: But now with the direction of the government policy, they want to introduce a more market driven approach to credit pricing, and they clearly are sending this message: you don't want to take state support for granted. So I think there is an example right now going on, and it's actually a pretty fascinating story. It's a large Chinese state owned distressed debt manager, over the years, it's become one of the largest issuers in Asia, one of the largest issuers in the entire emerging market, corporate debt space, and fairly widely owned by both Chinese and global investors as well. But they had this business strategy that deviated fairly meaningfully from the original and policy role, so not just investing in the country's bad debt. But so far year to date, you've had a couple of negative headlines and data points, and the market's been so fast to change its assumption about the state support.
Sheldon: So this credit was trading like an investment credit should be in the hundred odd handle at the beginning of the year, and now most of its bonds are trading more than a thousand basis points. You've had bonds sort of dropped down by thirty or forty points since the start of the year. The situation is still fairly uncertain, still very much in flux, but I think one implication here going forward is I do think you're going to see a lot more differentiation and how the market's going to price Chinese state-owned enterprises going forward.
Stewart: So when you look at Asia versus other EM fixed income markets, how is Asia distinct? And there's a couple of different aspects of this, right? There's domestic savings, currency risk, et cetera. How do you see, and you've talked about this somewhat to this point, but some distinctions between Asia and other fixed income markets?
Sheldon: Yeah. So a lot of angles to choose from. I'll try to unpack that in a few points. So reiterating the point I made at the beginning, I think the first thing to say: Asia is definitely the higher quality segment of the EM opportunity set. So twenty percent of that universe is from Singapore, Korea and Hong Kong. So these are AAA, AA economies, and pretty much as close to developed markets as you'll get anywhere. And even outside of those three, I think macro fundamentals for most of the region has been seeing steady structural improvement over the last ten, twenty years. The lion's share of the Asia corporate opportunity set is from countries that are typically very well anchored when it comes to fiscal sustainability, your balance, the payments positions, and also the political and institutional infrastructure. Most of these also have an investment grade sovereign rating and have seen upgrades over the past few years.
Sheldon: But, if you contrast that with some of the other EM regions, you have economies like Brazil, South Africa, Turkey that actually went in the opposite direction and became from investment grade into fallen angels.
Sheldon: And speaking of external vulnerabilities, I think Asia does tend to have as a whole, higher domestic savings and the current account surpluses, which does make it much more insulated when it comes to periods of global market volatility. Even when you think about countries like India, Indonesia, they were very much under scrutiny when we had the last paper tantrum in 2013, but that kind of account balances have improved a lot since then. And they should be in a much better position to weather any of those external shocks as well. The second point in terms of some of that difference is, market size for one, but also the technicals in the Asia market tend to be pretty strong.
Sheldon: The dollar bond market in Asia has grown very significantly and outpaces the growth of the rest of the EM market. It's now a $1.2 trillion market, which is pretty comparable in size to some of the more established and mainstream asset classes, like for instance, U.S. high yield, where there's less upside pressure on the issue and on the primary market growth as well. And the growth we've seen in Asia has been rather an average annual rate of mid-teens for the last decade and more. And because of that relative trend of primary activity, you get a lot more issuance now in Asia than you do in the rest of the EM. It's basically the fastest growing region within the broader EM, fixed income universe. And in terms of the technicals, I think there's the other side of that: the supply is growing, but the demand is also pretty strong and it's also the demand that's coming from within the region.
Sheldon: So when we were coming out of the financial crisis in 2008-2009, roughly half of the region's primary debt was being placed into Asian investors and the remaining 50% spread across Europe and U.S. in the major financial centers, but by 2020, that percentage has gone up to about 75% to 80%. So you have more of this dynamic of Asia buying Asia, and it's a bit of a home bias mentality. So again, when you have a global market sell off, you have these investors in the same region who are happy to hold on to the credit stories that they earn from and they're familiar with.
Sheldon: And I think the third point I'll make is on the sector mix. And I think what's worth noticing is that Asia, generally speaking, is less reliant on some of these extractive commodity economies. So you don't see that same magnitude of swings in boom and bust or commodity cycles. Like when you, you saw in default rates in Asia tended to stay pretty low in 2015 and 2016, when you had oil prices dropped so sharply and that pattern again, it shows up when you compare the high yield default rates, not just with the EM, but also more broadly with some of the developed markets as well.
Stewart: And you just used the word default in the last answer right at the end. So that leads me straight into the next question, which is: defaults in Asia, feel like a real risk for the first time in your mind, what's behind that? And what's the impact on investors?
Sheldon: Yeah. Nowadays you kind of troll through Bloomberg and it's hard to read any articles about fixed income in Asia without seeing the word default in them. So definitely a very topical story. So what's behind that? I think in terms of the backdrop, it comes down to the same point as before the policy objective in China to reduce risks in the financial system, reducing moral hazards in domestic credit markets and trying to get investors to have more credit discipline, and a much more market driven approach to pricing, bonds and pricing credit. So defaults are definitely going up, but it's only from a low base. So if you look back at in 2017 high yield default rates and the onshore Rehmann B market, that was well below 0.5%. So basically distressed companies are getting bailed out, losses weren't being imposed on investors. I think it's fair to say that 0.5% is a very artificially low number for a default rate.
Sheldon: Since then, we've seen the default rates go up. They're probably closer to 1.5% to 2% now. So rising, but from a super low base and still on the global context properly, I'd say fairly on the low side as well. So I wouldn't be surprised if that sort of stays relatively elevated going forward. I think the other observation to make though, is that policymakers have also wanted to calibrate that tightening policy in such a way that we don't see too much impact on the stability and confidence in financial markets. I like to think of it as a sort of a :two step forward and one step back” approach when it comes to managing the reforms of the onshore market. So if we are to see any spillover effects into onshore markets, I'd expect them to loosen markers and loosen policy accordingly to provide a bit of a boost.
Sheldon: Now, in terms of the impact on Asia dollar credit, I think there are some contagion risks we need to be mindful of. There is more correlation these days between spreads in the onshore market and offshore. Also if you find that onshore funding channels tend to shut off, that does raise some of the refinancing risks for potentially some of the names within our universe. You may also trigger some cross defaults into the dollar short bonds too. I think in part, market valuations are reflecting that, we're seeing a much more dispersion in credit spreads. Now five or 6% of our Asia opportunity set is now trading at more than a thousand basis points of credit spread. So these names are ready at distress levels. If one of them were to default, I don't think it's going to spook markets at all. Again, sort of the point I made similar about winners and losers in the property sector, I think is a similar thing to say here as well, defaults, credit impairments. That's going to remain very much a case by case thing. And so if you have a good bottom up process and credit selection, I think you can certainly navigate that. And I'm not so worried that the default rate story, which has been around for a while, I'm not so worried that it's going to dampen prospect for the asset class more broadly.
Stewart: So over the course of your answers, you mentioned that Asia is different than other EM markets in a variety of ways, right? Fastest growing area, a lot of differences in the structure of the market, which gets me to: do you see the differences warranting a standalone allocation to Asia EM? That's my term, right. But the Asia EM market as a standalone allocation?
Sheldon: Yeah. And I think to be fair, I think EM is a good way to characterize it too. So yeah, I think there are definitely arguments to make in favor of that. We touched on some earlier about the size of the markets getting too big to ignore in a way and that higher quality bias as well. So what does a standalone Asia credit actually look like? So we talked about the high-quality bias versus the rest of the EM. It would be a BBB plus asset class, 75% of the opportunity set is investment grade, $1.2 trillion available total, it's a sizeable opportunity set and a high quality one for people to get involved with. It's an under-penetrated market too, right? So the bond markets are still very much opening in Asia. You see a lot of new IPOs, those are going to be future issuers into the market.
Sheldon: And we're still seeing lots and lots of debut issuers coming every year to tap that market for, for new capital. I think the number is something like a hundred new credits coming to the market every year. And these are often going to be unfamiliar to the bondholder community. And when that adds some uncertainty to the price discovery process that can often lead to the dislocations and some of the attractive yields that you can achieve within portfolios. So I think that feature of being under penetrated, I think, makes a good case. And I think the second point, if you are making a dedicated Asia credit allocation, I think the real opportunity you're getting is an attractive risk adjusted return profile. So long term average returns have been about 6%, so pretty decent, and that has also come with lower historical volatility and lower drawdown risk then you get in more broadly.
Sheldon: And I think what's even more compelling is this comparison with developed market credit. So if you were to look at the March 2020 COVID sell-off, and I'm just going to compare here investment grade with investment grade, the investment grade segment of Asia credit actually outperformed U.S.. IG markets on the way down. So you had spreads widened in Asia, but they widened with about half of the BiTA we saw in U.S. IG. And this isn't a one-off, I think we've seen this pattern repeated over the years, maybe not to that magnitude, but certainly when you have periods of global credit sell-offs, Asia IG tends to be mostly as defensive as developed markets, if not more in some other cases. So the pitch I make is I think essentially you can own Asia investment grade credit with higher income, lower duration than U.S. IG, plus all the factors we've talked about earlier, and you can achieve some of that similar downside protection property as well.
Stewart: So can you talk a little bit- at the very outset you had mentioned T. Rowe and you're working with insurance companies. What are you seeing from--to the extent that you can talk about it--What are you seeing from insurance companies in this market segment?
Sheldon: Yeah, probably just sort of reiterate the point I was making a little bit early, I think, in this low yield environment, just the opportunity to enhance your income and get that with a reasonable amount of volatility, I think is attractive. And those are certainly the engagements we've had recently with some of the U.S. insurers. The messaging is along those same lines. This particular client we had is looking to create a more customized solution. We think that Asia credit does provide a lot of the tools for that portfolio construction process.
Stewart: It's really interesting that you had mentioned the risk adjusted return aspects. I think as, as the industry has taken on more and more risk chasing, more and more yield, it's certainly compelling, particularly from the duration perspective. So, I always end every podcast with the same question. And it's one that you've not prepared for but prepared for all your life. So I'm going to take you back to a day that you, I know you'll remember well, which is the graduation from your undergraduate institution. So no matter what happened Sheldon the night before, any sort of revelry or celebration, you are bright eyed and bushy tailed in your robe and cap and everything ready to go, right? So you wait, you wait, you wait, they call your name, up across the stage you go, you get a handshake and a photo op, as they hand you your diploma, you wave to the crowd. The crowd's going crazy, by the way, and as you go down the steps coming off the stage you run in to Sheldon Chan today. What do you tell your 21 year old self?
Sheldon: Yeah, that's a good one. I did engineering at university and straight out of that I went into finance.
Stewart: Well that's a natural path. I mean, what's wrong with that? That's totally normal.
Sheldon: Absolutely. Absolutely. A couple of things, so the first would probably be: it's important that the career path and the things you choose to do are something that you enjoy or at least be motivated by, right? Have a good reason to get out of bed and go to work every morning. And I think a crucial thing alongside that is, I think, good people that you're working with. I think that's super important to the enjoyment of the role. So we spent so much time working with our colleagues, whether it's in person, hopefully, but obviously these days are maybe a little bit more virtually for some, but I think if you can surround yourself with good people from different backgrounds, from different experiences, have different schools of thought, I think that makes your experience more enriching. So having good people to work with asking questions and learning from each other, I think certainly when I look back that's what's made sort of really enhance the enjoyment of my career so far.
Stewart: Good advice and good stuff. EM Asia with Sheldon Chan of T. Rowe Price. Sheldon, thanks for staying up late and being on with us.
Sheldon: Not at all. It's been a pleasure. I've really enjoyed this. Thanks a lot Stewart.
Stewart: I'm very glad to hear that. To our audience. Thanks for listening. If you have ideas for a podcast, we always want to hear them. You can email us at podcastandinsuranceaum.com. My name is Stewart Foley, and this is the Insurance AUM Journal Podcast.