Fidelity Multi Asset Income range Portfolio Manager Eugene Philalithis argues that traditional high-quality bonds have failed to offer diversification and defensive benefits through the recent market correction. With this in mind, Eugene discusses why they are increasingly embracing the growing opportunity set for income seekers in Asia, particularly among Chinese government bonds.
The composition of our defensive allocation has changed significantly in recent years away from higher quality duration assets, such as developed market government bonds and investment grade corporate bonds, towards Chinese government bonds.
We believe that high-quality duration bonds should add defensiveness to a portfolio. But for the past few years, this has not been the case. In addition, yields have been meaningfully lower than in the past. As a result, our recent exposure to high quality duration assets has been particularly low, if not the lowest in more than 10 years. This stance has been beneficial this year. Tightening financial conditions in response to high inflation have caused higher quality bonds to underperform sharply. In fact, these supposedly safer parts of the fixed income market have performed worse than both global high yield and global equity markets.
We embraced Chinese government bonds early, building up a meaningful allocation. This proved to be a good call given the extraordinary outperformance of China government bonds compared to developed government bond markets. This has led to better returns and, more importantly, greater defensiveness across our income portfolios. We have yet to sell any of our China government bonds. Fundamentals are still favourable - China is easing policy, the economy is slowing down and inflation is mostly under control, especially compared to the rest of the world.
However, the material repricing of high-quality duration assets this year now means that our previous concerns are diminishing. As a result, we have started buying back high-quality duration assets, across the curve and across both developed market government and investment grade corporate bonds. Our allocation to this part of the market remains marginal and any additions we make will be gradual, but we certainly think it’s a milestone worth highlighting.
Light at the end of the tunnel for Asia credit?
It has been a difficult 12 months for Asia credit markets, particularly China high yield (HY). However, we believe that the rally that began in mid-March could mark a turning point. There have been several false rallies in China HY over the past six months. At the turn of the year, it looked as though valuations were at rock bottom and policy easing would support the market. However, property developers make up a significant portion of the China HY universe, and the physical property market has continued to worsen, while liquidity conditions for property developers has failed to improve.
There have been two developments since then that have renewed our conviction. First, Liu He’s speech in early March was widely considered as a ‘China put’ moment, providing more concrete evidence of policy commitment to support markets that should help reverse the extreme negative sentiment. Second, there has been a noticeable drop in mortgage rates that should stimulate demand and therefore improve fundamentals for the property sector.
