Looking East for income opportunities

18 May 2022

Traditional high-quality bonds have failed to offer diversification and defensive benefits through the recent market correction. With this in mind, Eugene Philalithis, Portfolio Manager, Fidelity Multi Asset Income range, discusses why the team is 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.

China’s policy easing to date has been slower than we had expected. However, it is moving in the right direction, which is significant at a time when much of the rest of the world is hiking rates and unwinding quantitative easing. Volatility, defaults and bond exchanges will likely remain high. The fresh Covid driven strict lockdowns experienced in key cities in China will be another driver of volatility, as lockdowns will naturally delay housing activity, reducing the short-term impact of easing.

Despite this, we are now cautiously optimistic that the incremental easing measures and depressed prices will mean that our Asia credit exposure will be one of our better performing allocations this year, with the additional benefit of being lowly correlated to other credit and equity markets.

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Important information

This information is for investment professionals only and should not be relied upon by private investors. The value of investments and the income from them can go down as well as up and you may not back what you originally invested. Investors should note that the views expressed may no longer be current and may have already been acted upon. These funds take their annual management charge and expenses from your clients’ capital and not from the income generated by the fund. This means that any capital growth in the fund will be reduced by the charge. The capital may reduce over time if the fund’s growth does not compensate for it. The Fidelity Multi Asset funds use financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Changes in currency exchange rates may affect the value of investments in overseas market. Investments emerging markets can be more volatile than other more developed markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuer’s ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between different government issuers as well as between different corporate issuers. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the fund investing in them. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. Issued by Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0521/370816/SSO/NA

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