Matthews Asia Strategic Income Fund


Period Ended 31 December 2018

For the year ending 31 December 2018, the Matthews Asia Strategic Income Fund returned -4.02% while its benchmark, the Markit iBoxx Asian Local Bond Index, returned -0.44%. For the fourth quarter, the Fund was nearly flat at -0.36% versus 3.51% for the Index.

Market Environment: 

Asia's fixed income markets faced challenges in 2018. Starting in the second quarter, volatility was persistent across Asian credit, currencies and interest rates. This was driven by factors such as trade, stress in emerging markets, policy normalization from the U.S. Federal Reserve and an environment that transitioned from synchronized global growth to one in which U.S. growth remained robust while other regions slowed. 

The yield on the 10-year U.S. Treasury peaked in early November at 3.24%, up 83 basis points (0.83%) in the year. Late in 2018, as the threat of a disruptive trade war waned and commentary from the Fed became more dovish, U.S. rates moved lower. The shift led to a supportive environment for Asia's currencies, which outperformed the U.S. dollar into year end.

As we move into 2019, some big risks facing Asian economies have begun to fade. In the second half of 2018, consensus views of the U.S.—China trade dispute shifted toward an escalated and protracted conflict encompassing trade, investment, technology transfer and national security. A turning point was the G20 meetings in Buenos Aires in November as market volatility motivated both sides to talk. This paradigm shift was reflected in currency markets across the region, which depreciated versus the dollar in the first 10 months of the year, before rebounding as trade tensions dissipated. For instance, in the first 10 months of the year, high beta currencies such as the Indian rupee (-13.6%) and the Indonesian rupiah (-10.8%) depreciated significantly against the U.S. dollar. As trade tensions dissipated late in the year, both the rupee and the rupiah rebounded, with the rupee gaining 6.0% and the rupiah gaining 5.7%.

Returns in Asia credit were negative for the first time in five years, with spreads across investment grade and high yield issuers widening on the year amid the challenging macro environment. In general, performance was a function of credit quality, with issuers from the more highly rated countries of South Korea and Taiwan outperforming while issuers from Sri Lanka and Indonesia underperformed.

Stress in emerging market countries, such as Argentina and Turkey, also weighed on investor sentiment. While market sell-offs in Argentina and Turkey did not directly spread to Asia, high beta markets such as India and Indonesia, nevertheless, struggled in the third quarter. We believe this is unlikely to be repeated in 2019. 

Performance Contributors and Detractors:

For the full year, among the biggest contributors to portfolio returns were bonds denominated in Thai baht, Malaysian ringgit and Chinese renminbi (RMB). Our Thai baht performance was driven by the convertible bonds of Bangkok Dusit Medical Services, a Thai hospital company, which performed well on the strength of the underlying equity. Our Malaysian ringgit bonds were driven by government bonds, which provided attractive carry with minimal impact from currency depreciation. Our gains in Chinese RMB-denominated bonds was driven by a combination of RMB-denominated convertible bonds of China Railway Construction, and our allocation for much of the year to the high-quality onshore bonds of Chinese issuers. 

Among the largest detractors to Fund performance in 2018 were our holdings in U.S. dollar-denominated credits, as well as Indian rupee (INR)- and Indonesian rupiah (IDR)-denominated bonds. Asian credit spreads widened throughout the year, with issuers across the region coming under pressure. The Fund's holdings in companies such as Lippo Karawaci and Modernland in Indonesia, and Ctrip and Tsinghua Unigroup in China, detracted from performance. Our holdings in INR-denominated corporate bonds and IDR-denominated government bonds also performed poorly on a combination of currency depreciation and rising local interest rates. 

Notable Portfolio Changes: 

In the fourth quarter, we made a number of portfolio changes aimed at increasing our allocation to local currencies. We increased our currency exposure to countries across the region, including South Korea, Singapore, Thailand and Indonesia. South Korea, Singapore and Thailand are low-yielding countries, with interest rates lower than those in many developed countries. With little short-term upside to rates, we increased our exposure through currency forwards. In Indonesia, interest rates were significantly higher in 2018 as the central bank raised rates to defend the currency, and foreigners sold bonds and exited the market. We see room for interest rates to fall in Indonesia, and chose to add duration as well as currency exposure in the country. 

In the fourth quarter, we exited a handful of positions as we reshaped the portfolio. We sold the U.S. dollar-denominated high yield bonds of Lippo Karawaci and China Overseas Land & Investment. 

Outlook:

After significant repricing in 2018, we see the elements for strong performance across Asian credit, currencies and interest rates.
 
Since the Fed hiked rates four times in 2018 and stayed the course on balance sheet reduction, we expect no more rate hikes by the Fed in 2019. This would give Asia's policymakers the ability to slow their pace of rate hikes as well, and given that inflation remains low across the region, we see a broader drop in Asian interest rates.
 
Our outlook for Asian currencies is also positive. With U.S. growth still positive but decelerating and the Fed appearing to be on hold, we expect Asia's currencies to outperform. The significant drop in oil prices in the fourth quarter of 2018 also helped shore up oil-importing countries across Asia, providing a boost to foreign exchange reserves, current accounts and fiscal balances.
 
Finally, Asia high yield spreads offer attractive values for the long-term investor. With 12-month trailing default rates at 1.03% and spreads hovering around 6% at the end of 2018, the market has priced in substantially higher expected future defaults than the current run rate. We believe the major risks to the region, including a further slowdown in global growth, any escalation in trade shocks or further outflows stemming from policy normalization in the U.S., are priced in at these levels. Furthermore, based on our solvency and liquidity analysis, we do not expect any of the securities in the portfolio to default. As such, the relatively attractive yields in Asia offer a strong base for positive returns.
 
In sum, we see value in U.S. dollar-denominated debt of corporations in Asia because the valuation can be grounded in intrinsic value. As long as we maintain a long-term investment horizon of greater than three years and experience no defaults, the total return potential for Asia credit offers a compelling investment opportunity at current levels.


Rolling 12 Month Returns for the period ended 31 December 2018
Matthews Asia Strategic Income Fund 2018 2017 2016 2015 2014
I (Acc) (USD) -4.02% 9.06% 8.83% -1.03% n.a.
Markit iBoxx Asian Local Bond Index (USD) -0.44% 11.04% 1.73% -2.88% n.a.

Risk Considerations

The value of an investment in the Fund can go down as well as up and possible loss of principal is a risk of investing. Investments in international and emerging market securities may involve risks such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. Fixed income investments are subject to additional risks, including, but not limited to, interest rate, credit and inflation risks. The Fund may invest in the following: derivatives which can be volatile and affect Fund performance; high yield bonds (junk bonds) which can subject the Fund to substantial risk of loss; and structured investments which can change the risk or return, or replicate the risk or return of an underlying asset. The Fund invests in holdings denominated in foreign currencies, and is exposed to the risk that the value of the foreign currency will increase or decrease. These and other risks associated with investing in the Fund can be found in the Prospectus.

Performance figures discussed in the Fund Manager Commentary above reflect that of the Institutional Accumulation Class Shares and has been calculated in USD.  Performance details provided for the Fund are based on a NAV-to-NAV basis, with any dividends reinvested, and are net of management fees and other expenses.  Past performance information is not indicative of future performance. Investors may not get back the full amount invested.

The information contained herein has been derived from sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Matthews International Capital Management, LLC (“Matthews Asia”) and its affiliates do not accept any liability for losses either direct or consequential caused by the use of this information. 

Information contained herein is sourced from Matthews Asia unless otherwise stated. The views and opinions in this commentary were as of the report date, subject to change and may not reflect the writer’s current views. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Fund’s future investment intent. It should not be assumed that any investment will be profitable or will equal the performance of any securities or any sectors mentioned herein. The information does not constitute a recommendation to buy or sell any securities mentioned.

Investors should not invest in the Fund solely based on the information in this material alone. Please refer to the Prospectus for further details of the risk factors.

Sources: Brown Brothers Harriman (Luxembourg) S.C.A, Matthews Asia, FactSet Research Systems, Bloomberg