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THE Lehman Brothers collapse in September last year turned what was promising to be a bad economic downturn into a systemic crisis with the potential to rival the Great Depression. The resulting pressures on the banking system meant that by the end of 2008, credit valuations fell to unprecedented levels and were pricing in economic Armageddon.
However, policy responses extraordinary in both scope and magnitude were soon employed across the world, making a catastrophic outcome far less likely. This has led us to view 2009 as a year of healing for global credit markets, including those in Asia. In fact, we called 2009 'The Year of Credit.'
In an environment of deflationary pressures and low projected returns, a strong case could be made to hold credit, not only on a relative basis to other asset classes but also an absolute one - the extreme depths of the discounted prices meant considerable downside protection.
As we began to market our call, we quickly realised that private wealth clients in the region were paying attention. In just a few months, their inflows became key drivers of regional credit markets, contributing significantly to stabilising the asset class. This was particularly true for not only convertible bonds, but investment-grade bonds and high-yield debt as well.
The rise of the buy-backs
We also noted particular interest from investors in new issues from high-quality Asian companies. Unfortunately, that demand had to overcome a somewhat surprising obstacle - while new issuances were taking place in the US and Europe, Asian investment-grade corporations were beginning to buy back their own debt.
Indeed, while governments around the world were losing no time getting on their feet with supportive measures, Asian companies were also engaging in self-help. By buying back their own bonds in front of the eyes of investors who had expected a wave of new issuance, they proved in the process to be savvy bond investors themselves.
After all, buying back debt makes sense for companies whose returns from doing so exceeds the alternatives (the 'willingness') and where the corporate liquidity profile is strong (the 'ability') - corporate finance 101 arguments that had not stood so strong for a long while.
A more important incentive to buy back debt is that it enhances both credit and equity performance. In an environment where equity markets were increasingly driven by concerns over corporate liquidity, the debt buy-backs were signals of the strength of balance sheets.
And by turning out to be overall net buyers of credit markets, Asian issuers were themselves lending further support to their own markets.
Should we expect to see the wave of buy-backs to continue? Ultimately, we believe some Asian issuers will remain just that - issuers. In fact, we expect a radically two-tiered Asian debt market, where high-quality bonds are sought after by investors and the issuers themselves, while others remain forced issuers.
High yields start to shine again
In line with our earlier call on Asian credit, Asia has, by far, been the best performer among global credit markets to date. In particular, the Asian high-yield market has turned from a forgotten universe into a star performer.
While this surprising rally could easily be dismissed as nothing more than a misplaced short-covering bounce, we believe the Asian high-yield market is different from most other corporate credit markets globally, and that there is more to the asset class.
More than any other set of companies globally, the Asian high yield universe relies on growth and external funding to service debt, which makes it extremely vulnerable to a cut-off in credit availability. That built-in volatility, however, also works the other way once credit conditions improve. Good companies with weak credit metrics can quickly turn into good credit stories once funding is available.
More importantly, credit growth is holding up well in Asia. Despite a shrinking high-yield bond market, loan growth for the asset class is proving very resilient in the places that matter most - China and Indonesia. Together, they make up more than half of the total outstanding bond volumes. The trends are almost as strong in the Philippines and Thailand, which together make up another 15 per cent of the market.
While strong credit growth has provided clear support for the Asian high-yield market so far, there have been inevitable questions over its sustainability. Although our Asia ex-Japan banks team expects loan growth in both China and Indonesia to moderate from current levels, its base case is still for growth to remain strong for the rest of the year. After all, banks in both countries are essentially deposit-funded, and among the most liquid in the region.
Unwinding credit risk premium
Still, after the strong run-up in Asian credit in the first half of this year, it is not surprising that some of the questions recently posed by our private clients are: have they missed the boat for credit markets? Is it too late to enter Asian credit now?
As far as we are concerned, the answer to both questions is no. While spreads have tightened significantly from the December 2008 highs, we believe the opportunities in credit markets look far from over.
Broadly speaking, despite the size of the rally, current credit spreads are still pricing in exceptionally high default rates, and current levels are still wider than the historical peaks in previous default cycles.
Add to this the fact that the Lehman Brothers fallout has had the double impact of not only pushing spreads in Asia to historical width, but also creating a specific 'Asia credit risk premium'.
This risk premium widened when banks globally came under funding pressure and interbank lending markets dried up - the capital market equivalent of a run on banks. And when Western governments stepped in to provide liquidity support to their own banks, Asian banks came under greater pressure, given non-AAA rated Asian sovereigns' natural disadvantage in matching that support, as well as investors' 'fresh' memories of the Asian crisis only 10 years earlier. This caused the premium to gap even higher.
But with systemic healing now under way globally, and the worst fears about Asia proven unfounded, we view the 'Asian credit risk premium' over US spreads as increasingly unjustified, and expect most of it to gradually disappear.
While the post-Lehman credit freeze has undeniably made the economic downturn in Asia much worse through weaker exports and trade finance and greater cost of capital, it did not trigger a systemic failure. Almost two years into the downturn, Asia stands out in that no major bank has collapsed or had to be nationalised, and credit growth has proved very resilient. Indeed, Asia is experiencing a re-intermediation process in credit.
Why has this been so? Two structural differences between Asian and US banks have proved important: first, less reliance on wholesale funding; and second, less leveraged balance sheets going into the downturn. Together, these factors have contributed to the failure of the feared impact to materialise, and as a result, credit losses in the region have been lower than elsewhere.
Furthermore, one often-cited argument in favour of an Asian credit risk premium over more mature credit markets is proving increasingly hollow - the benefits of a transparent bankruptcy regime such as Chapter 11. Granted, the lack of an established and transparent bankruptcy process is a major impediment for the development of Asian credit markets, but with Asian recoveries so far proving no worse than that in US, the value of transparency is proving somewhat insignificant.
The writer is head of Asia Credit Research and Strategy, Morgan Stanley
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