• 08/09/2017

Embracing China’s “New Normal”

Embracing China’s “New Normal”

by bm editor

Ben Yuen, Managing Director, Head of Fixed Income – BOCHK Asset Management

There is a reason this House Award winning in the RMB High Yield Income space receives much attention from professional investors. BENCHMARK explores the tactical strategies BOCHK Asset Management uses while not losing its human touch.

BENCHMARK: Congratulations, Ben, on making a strong case for investors looking for broad RMB High Yield Fixed-Income exposure. Can you tell us your investment philosophy?

Ben Yuen: Thank you. It’s been an honor. Our investment philosophy always has been to maximize returns through active risk management and disciplined portfolio construction, and we seek to generate consistent investment returns by focusing on fundamental and quantitative research. We are benchmark-aware but not benchmark-driven. We take the interests of our shareholders at heart, and we recognize wealth conservation is just as important as wealth creation. Therefore, we adopt a prudent approach to minimize downside risks during market distress. We believe that a disciplined and comprehensive process of evaluating values and risks is essential for superior and consistent investment performance.

BM: How does your bottom-up relative value comparisons work for credit selection, and what is the average credit quality?

BY: For each investment we assign and maintain an internal credit rating with our Momentum Score (MS) and Information Quality (IQ) Score. Our daily market presence enables us to be proactive and timely on credit calls, and MS assigns a positive/negative outlook, over a time frame, for credit improvement/deterioration. We understand that other agencies rarely include this measure due to differences in the business model. MS requires our forward-looking estimation while we evaluate the attractiveness of bond yields vs. credit ratings. As a proxy to Moody’s KMV Model, and by using in-house tools to alert us on a daily basis, we can analyze changes in both stock prices and implied volatility to capture early signals of credit profile changes.

Tackling Risks

BM: Being a high yield portfolio operated in a country with significant governance risk, even at the sovereign level, how do you tackle this issue?

BY: Our IQ score reduces the risk of garbage-in-garbage by first judging the credibility of the financial data provided by the issuers. We systematically evaluate the corporate governance and credibility of the issuers’ senior management, which rating agencies will not be able to incorporate. Our analysis covers the study of bond indenture to evaluate bondholders’ protection such as shareholders’ subordination of an issue, the legal structure of the issuer/guarantor, tax withholding issues, call risks, and governing laws, etc. We also undertake face-to-face meetings with senior management while cross checking their equity stories.

Our in-house Sovereign Risk Analytic Framework (SRAF) evaluates the sovereign credit risk of both developed and emerging market countries. The SRAF, which covers 116 countries with data back to 1994, analyzes country political risks and quantitatively gauges solvency and liquidity risks.

BM: How do you see risk and how is downside managed?

BY: We pay significant attention to downside risk management, and when facing serious market risk, we are prepared to be defensive in managing downside risks even it means compromising our upside potentials. We are constantly reminded of the value of risk principle, and we find yields that are relatively attractive to compensate for our clients’ risk taking in interest rates, credit, and liquidity risk. Our deep understanding of macroeconomics and geopolitics also prepares us for possible events in the Asian and RMB bond markets.

BM: How do you monitor your portfolio over time for breaches and downgrades?

BY: Our portfolio risk-process enables us to review daily constituent bond price variance reports and set alerts to variations >1.5%. Our daily credit rating variance reports reflect changes in a bond’s classification within 24 hours. Our proxy to Moody’s KMV alerted us daily on stock price changes and implied the stock price of a listed bond issuer in the portfolio to be set at >3%. Spread and interest rate durations are also used for measuring credit and interest rate risk. We also conduct various scenario analysis and stress tests to gauge performance downside risks.

Looking Ahead

BM: Are you concerned about the continuous slowing down of China and its property sector?

BY: In our view, the lower economic growth in China under the “new normal” scenario is more sustainable. In fact, China’s real GDP was up 6.9% YoY in 2015, outperforming most of the emerging market peers. The government has been devoting great efforts to stabilize the growth, and we expect progress on the state-owned enterprise (SOE) reform. The Belt and Road, together with other the structural reforms would also support China’s economic growth over the medium to long run.

As for the property market, average inventories in both first and second tier cities have now reduced to more reasonable levels. Demands are strong in first-tier cities as shown by rising property prices. Although property markets in lower-tier cities are under some stress, the government has launched a series of policies to stimulate demand in those cities. We also believe China’s property markets can benefit from the government’s strong intention to push the urbanization process.

BM: How are you taking advantage of the RMB liberalization between onshore, offshore and USD hedges?

BY: This feature allows us to find the best investment opportunities through different dynamic cycles in the three tiers of markets. Currently, offshore CNH bonds and USD hedges bonds may offer a better risk-adjusted return. Therefore, our focus on exposure is in these two markets.

BM: How do we read the volatility we have in China right now?

BY: We see ongoing significant market volatilities in China, both in the equity and the FX market. Main driving factors include, firstly, the economy still faces significant downward pressures under the “new normal” scenario. Manufacturing sector and traditional industries remain subdued due to weak domestic and global demand. We think economic modernization may be the fundamental reason leading to recent volatilities. Secondly, as the US dollar keeps strengthening along with the Fed’s normalization of monetary policy, the worsening cross-border capital outflows will increase global pressure on the CNY as well as other asset prices. Thirdly, the Chinese stock market is undergoing a deleveraging process, causing short-term downward pressures on equity prices. Finally, there was some negative sentiment among international speculators targeting China, but we expect their influence on investors’ confidence is only short-term and soon subside.

BM: Apart from the dominant role property plays in the high-yield space, what other stories and themes look favorable?

BY: Besides the property sector playing a dominant role in the high yield space, we also view the consumer staples sector and the China local government financing vehicles (LGFVs) good investment options on the premise of cautious name picking. In the context of global economic slowdown, the defensive consumer staples sector tends to be a more rational choice compared with other cyclical sectors. As for the China LGFVs, the implicit guarantees from local governments shall reduce short-term default risk although financial weakness may raise some concerns. We expect policies continue to be accommodative for China LGFVs, as the Chinese authorities emphasize greatly on infrastructure investments for the purpose of stabilizing economic growth.

BM: With China moving towards a servicing economy, what sectors will benefit?

BY: With the GDP contribution from the service sector exceeding the secondary industry in China, we see potential investment opportunities in sectors such as tourism, department stores, and internet-related technology. China is in the process of upgrading its consumption structure, and rising national wealth will increase demand in the tourism industry and enhance corporate profitability. The retail sector will also benefit from consumption upgrading process as we expect further upside for these sectors when the government progresses on stabilizing economic growth. The Internet-related technology industry can also take advantage of the government’s supports in promoting the theme of the “Internet+” initiative for critical sectors on the supply-side.

BM: Going forward in 2016, how do you see the income sleeve of return to be consistent and not having to rely on lower-quality securities?

BY: On one hand, after the market correction at the beginning of 2016, valuations of the Asian high yield universe have become attractive again. Our portfolio strategies do not require moving down the credit curve to pick up extra yield. On the other hand, due to the contagion effect of falling oil prices, some selective U.S. high yield bonds may become our target to acquire in 2016. BM