For the year ending December 31, 2020, the Matthews Asia Credit Opportunities Fund returned 0.48% (A Acc Class) and 0.93% (I Dist Class), while its benchmark, the J.P. Morgan Asia Credit Index returned 6.33%. For the fourth quarter of the year, the Fund returned 4.01% (A Acc Class) and 4.14% (I Dist Class) versus 1.82% for the Index. 

Market Discussion:

2020 marked the end of a credit cycle—defined by a trend of falling spreads—as the global pandemic roiled markets. It also marked the beginning of a new credit cycle, as spreads staged a remarkable recovery as governments globally committed to unprecedented monetary and fiscal support to backstop the global economic recession due to COVID-19. Unlike past credit cycles where the lack of liquidity was the primary driver of defaults, solvency is becoming the primary driver as vulnerable sectors saw revenues, profits and free cash flows plummet and working capital needs rose. Fortunately, many Asia countries, led by China, have staged a remarkable recovery and do not appear to be suffering from long-term structural damage as containment proved to be relatively swift. Emerging Asia’s recovery has been relatively slow and uneven with containment incomplete including in India and Indonesia. This dichotomy has also been playing out with companies, with larger companies having unfettered liquidity while smaller companies struggled to survive.  The year closed with Asia default rates at 3.5%, compared to 9.7% in the U.S.

The fourth quarter can be described in two distinct sub-periods: before and after the U.S. election in November. The first month was dominated by worries, while the latter period provided a welcomed respite and positive returns across almost all risk assets. The average spread of the J.P. Morgan Asia Credit Index tightened 39 basis points (0.39%) in the quarter while the high yield portion of the Index tightened 98 basis points (0.98%).

In the pre-election period, there were several sources of uncertainty: conflicting news on the likelihood of U.S. fiscal stimulus with the market widely perceiving a second stimulus as necessary given the weakened U.S. economy due to the pandemic; large increases in daily new confirmed cases of COVID-19 in the U.S. and Europe; and highly uncertain election results. And in Asia, the large divergence of recovery between East Asia (China, Japan, South Korea) and the rest of Asia and room for further fiscal stimulus was an additional question. These uncertainties led to market caution early in the quarter.

In the post-election period, risk sentiment improved for a number of reasons, including a Democratic Party win with the possibility that Democrats might take the majority in the Senate—viewed as having a much higher chance of passing a large stimulus. At the same time, successful COVID vaccine trials brought in view the end of the pandemic. The fact that a “Hard Brexit” did not materialize was an additional piece of good news. Within Asia, we saw volatility after President Trump signed Executive Orders directed at China. One Executive Order stipulates that all U.S. funds must divest from a list of Chinese companies associated with the military.

Performance Contributors and Detractors:

In general, lower-rated securities outperformed higher-rated securities in the fourth quarter. The portfolio’s overweight in BB-rated securities helped Fund performance. Basic industries and real estate were the top contributors to performance, driven by securities such as Indika, Tata Industries, and Adaro within basic industries, and within real estate, Lippo Karawaci, KWG, and CIFI. However, security selection in Pan Brothers detracted from performance, as Pan Brothers was downgraded during the quarter due to concerns about their ability to refinance outstanding bank loans. In addition, exposure to Luye Pharmaceutical, a Chinese pharmaceutical company, also detracted from performance.

For the year 2020, Fund performance was mainly hurt by our overweight to high yield credit relative to investment grade, which had outperformed in the year as markets sought “safety”. But security selection in the investment grade space, including Syngenta and longer-dated Indonesian quasi-sovereigns credit, helped the Fund in the year.

In terms of country allocation, overweights in India and Vietnam were the top contributors while allocation to Indonesia, which failed to effectively control COVID-19, and Sri Lanka, which was hurt by pandemic-driven declines in tourism, were detractors. Within China, Fund performance was roughly in line with the benchmark. Contributors included real estate developers and internet names such as Baozun and iQiyi, while underweights in investment grade-rated names detracted.

Notable Portfolio Changes:

2020 was a year of many surprises and required continual rotation in search of value. We sold names that had benefited or recovered quickly from the COVID-crisis such as Weibo and Citic Telecom and redeployed capital into what we believed were good companies where recovery was more delayed, including Chinese apparel brand Bosideng, and Jollibee, a Philippines restaurant chain. We reduced risk in Pakistan and Sri Lanka as we expected frontier markets nations to have both less ability to deal with a public health crisis and slower economic recoveries. We also rotated capital within Indonesia, from investment grade state-owned companies, such as InAlum and Cikarang Listrindo, into higher yield names, such as Sritex, a textile manufacturer, and Adaro, a coal miner. We also added high yield names such as Tata Motors of India, which has embarked on an ambitious debt reduction plan.

In the fourth quarter, we exited Chinese apparel maker Bosideng as it had rallied substantially and hit our price target. We switched out of China Jinmao as we saw rising risks associated with Chinese state-owned entities after the passage of President Trump’s Executive Order. We added Times China in replacement, as we liked its exposure to the fast-growing Pearl River Delta region. We added the convertible bonds of South Korean internet firm Kakao (Daum) to increase exposure to the high-growth tech sector.

Outlook:

Having experienced the worst of the credit cycle in 2020, we expect markets and economies globally to continue their recoveries in 2021. We will likely see policymakers gradually ease up on the unprecedented levels of support and accommodation seen in 2020, but largely expect monetary and fiscal policies to remain supportive for the foreseeable future.  As such, we expect default rates in Asia to tick up slightly from 2020 year end levels and stay well contained in the mid-single digits.

Despite the strong support of policymakers, we continue to monitor some key risks, including new variants of COVID-19 and how this might affect the economic recovery. Additionally, we are watching the pace of recovery of countries such as China which has largely contained the virus. While we do expect further U.S. stimulus as well as vaccine distribution to solidify the economic recovery going into 2021, we are monitoring for any disruptions to the base case. In this base case, we believe that U.S. dollar-denominated, non-investment grade Asia bonds potentially offer the most attractive risk-adjusted returns.

Looking ahead, we are cautiously optimistic that U.S. – China relations could normalize to a more rules-based and engagement-based way of interaction. While the U.S. will continue to focus on rectifying grievances in trade and technology competition, we are hopeful that less erratic, Executive Order-driven policies will reduce Asian markets’ volatility.                                 

As markets continue to assess the uncertainties, we expect idiosyncratic risks and company-specific risks to be the dominant concern for markets. We believe the market will shift its focus to determine to what degree each sector and each company is affected by the imminent vaccine distribution. As a result, dispersion between geographical regions and between different credit qualities will increase going forward.