Asia Credit Strategy:Thoughts on the HY sell off

To start, the sell-off in HY hasn’t been as bad as headlines suggest. HYG, thebiggest US HY ETF is down about 1.8% from the recent highs on Oct 20. It hasseen a similar or bigger drop 3 times already this year (Figure 1). Clearly,certain specific bonds in US HY are down a lot more, driven by name specificheadlines (results, M&A) but the overall widening so far is not uncommon. AsiaHY bonds are performing broadly in line, down 1-2 points on average, withsome of the more liquid recent new issues losing 2-3 points and the seasonedones dropping less than a point. We can hardly count five bonds in all that aredown more than 2 points (excluding distressed names). In spread terms,Markit HY index is 15bp wider since Oct 20. Again, this is quite common, withsimilar widening witnessed 6 times already in 2017 (Figure 2). We haveanalyzed Asia HY’s recent performance in a bit more detail later.

    We all have read about US HY outflows, and know about tight valuations andpossible year-end profit taking. There have also been name specific negativenews as mentioned above, mainly in the TMT and Healthcare sectors. Potentialtax reforms that plan to cap interest tax deduction at 30% of EBITDA andsubsequent talks about delay in tax cuts have not helped. A few HY dealsgetting pulled last week didn’t help sentiments either. In contrast, we havebarely seen any new headlines in Asia HY and EM hard currency fund flowshave been positive, so the widening here seems in sympathy of US HY. Wedon’t think the weakness in Asia HY is supply driven, as the sector that hasseen the most new issuance, China property, has held up relatively well.

    The selling appears mainly positioning driven to us. We don’t see any materialfundamental changes. If anything, Moody’s is forecasting US HY default rateto decline further from 3.3% currently to 2.3% next year. Higher economicgrowth usually keeps default rates low. US is also coming off a strong resultsseason as we know. Further, oil is an important determinant of US HYperformance and the Middle East tensions at least put a floor to the oil price.

    OPEC is largely expected to extend the production cuts beyond March’18 at itsmeeting later this month. Separately, we are aware of the typically highcorrelation between HY and equities, and DB’s strategist, Binky Chadha istargeting 2,850 for S&P by YE2018, primarily from 11% EPS growth.

    Most of these fundamental arguments hold true in Asia as well. While oil is notas important here, default rates are quite low at just ~1% this year. Earningshave been good with almost 75% of the companies that have reported so far inAsia ex-Japan beating expectations. More importantly, we have argued beforethat balance sheet leverage seems to be peaking and corporates have beenproactive with refinancing. Having said this, we do have an eye on the largematurities next year in the China property sector, the 364 bonds and newissues in the China non-property world that are unrated and/or unlisted. On aseparate note, in our view, investors are largely disciplined with new issues(with the exception of perhaps China industrials HY) and we are still seeingweaker deals being pulled for lack of demand. Net net, we believe this HY selloff,which hasn’t really been meaningful so far (except in select, weakernames), will eventually be a buying opportunity, and maintain our strategy ofbeing Overweight HY vs. IG (in total returns).