In June, the Asia (ex-Japan) fixed income market came under intense pressure as the market was buffeted by a series of negative headlines and credit events. Concern over a breakdown for the bailout package for Greece led to a broad based selloff in risk which was exacerbated by disappointing economic data out of the US and growing concern over the impact of continued policy tightening in China.
Although risk assets managed to stage a recovery at the end of the month on the back of Greece’s approval of the necessary austerity measures to ensure the release of the next tranche of aid and some stabilization in the economic data, market sentiment remained decidedly weak. Regional equity markets gave up all their gains for the year as the MSCI Asia Ex-Japan Index ended June down -2.70%, led by Hong Kong’s Hang Seng Index which fell -5.40% for the month. Implied volatility across the region increased from 3.5-7.4%, mirroring the spike in the VIX Index to a three month high of 24.65. Asian credit spreads rose to their widest levels of the year as investors pared down risk in the face of deteriorating market conditions. US Treasury yields initially rallied on the weak economic data, benefitting from safe haven flows which sent yields to recent lows, before shooting higher during the relief rally at the end of the month. Yields ended the month up by 6-15 bps across the curve. Asian currencies and rates were mixed, reflecting the overall lack of confidence and weak market tone, which kept most investors sidelined and risk appetite muted.
The collapse in the bonds of Sino-Forest at the start of the month set the tone for Asian credit markets. Previously considered as one of the higher quality names in the Asian high yield market, the bonds of Sino-Forest plummeted by 70% to distressed levels following accusations that the company was fraudulently exaggerating the size of its assets and sales. Coming on the heels of the recent corporate governance issues of China Forest, Asian high yield bonds sharply fell in sympathy. As a result, the average high yield corporate spread widened by 27 bps to 620 bps. China property and non-property bonds led the market lower, dropping 1-3 points, as investors sought to reduce exposure to issues with higher perceived corporate governance risks.
The weak market environment hit the broader market as well, with the composite average spread widening by 16 bps to 296 bps and the average investment grade corporate spread widening by 22 bps to 270 bps. Higher-beta issues such as bank sub-debt and China corporates were sold off the hardest. The lone bright spot in the market was the sovereign bonds of Indonesia and the Philippines which managed to end the month higher in price on the back of a ratings upgrade for the Philippines and strong on-shore demand. Primary activity dramatically slowed during the month, despite the heavy pipeline. Total issuance fell to USD 5.3 billion for the month as several issues were pulled/delayed due to the poor market conditions. CDS spreads maintained their outperformance relative to cash bonds resulting in a further widening in the cash-CDS basis. The Itraxx Asia Ex-Japan Investment Grade and Sovereign indices were wider by 5.5 bps to 113 bps and 8.0 bps to 122 bps, respectively. Thailand’s sovereign CDS was the major underperformer, widening by 19 bps on concerns over the elections in early July. China’s sovereign CDS was also well bid, widening 11 bps as investors sought “tail” hedges against a possible hard landing in China and growing concerns over deteriorating asset quality at Chinese banks.
Asian convertible bonds were down -2.02% for the month as heavy new issue supply coupled with weak equity and credit markets resulted in most issues cheapening considerably. Performance of regional currencies and rates were mixed as headlines and positioning dominated trading. While CNY gained 0.23% in June, the 1-yr implied NDF appreciation weakened by 64 bps to 1.27% on stale position unwinds. KRW was the outperformer, gaining 1.08% on better than expected current account and IP data. THB and MYR were the main underperformers, weakening -1.4% and -0.33%, respectively. For June, the Merrill Lynch Asian Dollar Index was down -0.24%.
June’s fund performance was down primarily due to losses in the Covenant and Distressed sub-strategies. The Covenant sub-strategy accounted for -0.30% of the month’s negative performance due to the outperformance of Philippines and Indonesian sovereign spreads and a decline in the price of Vinashin’s loan. Although Vinashin failed to make the scheduled interest and principal payment due at the end of June as expected, a further delay in its presentation of a restructuring proposal to creditors resulted in its claims being marked lower. The Distressed sub-strategy posted negative performance of approximately -0.20% in line with the weakness of the overall market. Despite the increase in implied volatility in June, the sharp rally in the KOSPI during the last week resulted in the fund’s volatility hedges contributing negatively for the month by -0.20%. The general underperformance of cash bonds compared to CDS also negatively impacted performance, costing the fund about -0.10%. Positive performance was primarily due to the positive carry of the Yield sub-strategy, which was up around +0.30% and the Inter-company strategy which was positive due to its net short positioning.
The fund used the weakness in June to selectively add exposure. The bulk of the increase in net exposure was driven by additions to the Intra-Country, Yield and Capital Structure sub-strategies, respectively. As a result, the fund’s net exposure, VaR and CS01 moved higher compared to the previous month, but still remain relatively defensive.
Although we expect markets will remain volatile as European headlines continue to dominate market sentiment, we believe the most recent widening in credit spreads has resulted in certain parts of the market becoming attractive, which is why we have started to add risk. Additionally, market technicals appear more favorable as dealers have reduced risk during the recent market weakness and to our surprise, capital continues to flow into the region. With the primary pipeline self-correcting for the weaker market environment and growth expectations being revised to more realistic levels, we have become more constructive on the market and second half outlook.