Matthews Asia Strategic Income Fund
Period Ended 30 September 2018
For the quarter ending 30 September 2018, the Matthews Asia Strategic Income Fund returned -0.72%, while its benchmark, the Markit iBoxx Asian Local Bond Index, returned -0.51% over the same period.
Asia's fixed income markets faced a number of challenges in the third quarter. Second quarter volatility carried over into the summer, and factors such as trade, stress in emerging markets and policy normalization from the U.S. Federal Reserve combined to create a perfect storm for Asia credit, currencies and interest rates.
The dollar and U.S. rates continue to be in focus for investors around the world. The yield on the 10-year Treasury rose 20 basis points (0.2%) in the third quarter, and commentary following the Fed's rate hike in late September left little reason to expect that the Fed was near the end of the rate-increase cycle. The evolution of global growth also contributed to the strong dollar. Growth in the U.S. continues to hold firm, while other regions of the world have seen growth moderate.
The ongoing trade dispute between the U.S. and China is perhaps the biggest challenge facing Asian economies. Consensus views seem to have shifted from expecting a negotiated and minimally disruptive trade agreement to an escalated and protracted policy of containment involving trade, investment, technology transfer and national security between the two countries. The impact of such a paradigm shift is difficult to fully gauge, and the uncertainty around it has weighed on investors, companies and countries alike. One way the uncertainty was reflected in markets was in local currencies, with most Asian currencies down -1% to -5% versus the dollar in the third quarter.
Stress in emerging market countries such as Argentina and Turkey also weighed on sentiment for investors in Asia. While Argentina's and Turkey's sell-offs might not have a direct contagion to Asia, nevertheless, high beta markets in Asia like India and Indonesia struggled in the third quarter, with rates higher and the currency weaker in both countries.
While Asian interest rates rose and Asian currencies were weak, the lone bright spot in the third quarter was in Asian credit, where spreads tightened both in investment grade and high yield credit. Despite the relative strength, we expect credit markets to remain challenging. For instance, the weakness in the Indonesian rupiah has weighed on the bonds of Indonesian corporate issuers. Indonesian companies that borrow in U.S. dollars are required to hedge a portion of their currency exposure, but as the rupiah depreciated it moved beyond the levels that were hedged, leaving some companies fully exposed to further rupiah depreciation.
With a challenging environment in Asia, security selection is paramount and we continued to move our portfolio into low duration, higher quality issuers where we believe we are well-compensated for the risk.
Performance Contributors and Detractors:
In the third quarter, among the biggest contributors to portfolio returns were our holdings in the bonds of Lippo Karawaci,1 Alam Sutera Realty and SoftBank Group. Lippo Karawaci and Alam Sutera are both Indonesian property developers. After selling off as the Indonesian rupiah depreciated in the second quarter, the bonds of both companies rebounded in the third quarter. SoftBank bonds also rebounded as the firm moved closer to the planned IPO of its Japanese wireless business, which may be among the largest IPOs ever.
The largest detractors to Fund performance in the third quarter were our holdings in the bonds of Ctrip.com, Qingdao Haier (issued by Harvest International), and HDFC. Both Ctrip.com and Qingdao Haier are convertible bonds of Chinese issuers. Ctrip.com is one of the largest online travel agencies in China, and its bonds performed poorly as the underlying equity lost over 20% in the quarter on rising competition and a weak domestic market. Qingdao Haier, which we exited during the quarter, manufactures household appliances, and its bonds fell as the company faced a challenging environment and battled revenue growth deceleration. HDFC is an Indian rupee-denominated bond, and it performed poorly as the rupee depreciated and yields in India rose and one of its portfolio holdings.
Notable Portfolio Changes:
In the third quarter, we made a number of changes to our portfolio aimed at migrating it from local currencies to U.S. dollars. We closed out of our long currency positions in the Korean won, Thai baht and Singaporean dollar. We also sold local currency bonds to reduce our weights in the Chinese renminbi and Indonesian rupiah, and exited our position in Malaysian government bonds.
In the third quarter, we added a number of U.S. dollar-denominated bonds that we believe have attractive yields relative to the risk we are taking. By buying high-quality sub-investment grade bonds with maturities from 2019 to 2021, we were able to lock in yields of more than 5% without taking on excessive interest rate or credit risk. For instance, our research shows bonds of Aluminum Corporation of China (Chinalco Capital Holdings), Olam and West China Cement have minimal default risk and solid balance sheets. We also added bonds of Krung Thai Bank in Thailand. Krung Thai is a high-quality bank, and because the coupon on the bonds increases significantly late next year, they are likely to be repaid by the company before the higher coupon takes effect.
We see Asia's fixed income markets remaining volatile through the end of 2018. While current prices have corrected to account for much of the uncertainty in the global environment, potential risks remain.
We expect U.S. rates to set the tone for local rates in Asia's developed countries as the U.S. economic cycle gathers momentum and finally starts to create mild inflation. Recent U.S. Federal Reserve commentary has led to somewhat higher expectations for rate increases for the remainder of 2018 and 2019. The wild card is for tariffs to create inflation in the U.S. as companies decide to pass on some of the tariffs to the consumer. In that scenario, the Fed might be spurred to raise rates faster than current expectations.
Our outlook is for Asian currencies to remain weak into year end, continuing the trend we have seen since the second quarter. Trade tensions between the U.S. and China are one factor driving negative Asian currency performance. India and Indonesia remain particularly vulnerable to portfolio outflows and rising oil prices ahead of next year's elections.
Finally, Asia high yield spreads are now significantly wider than historical averages. Here, too, there is potential downside in the negative headlines associated with the inevitable rise of defaults in China. While we have consistently highlighted the need for more defaults to drive more appropriate credit risk premia onshore, some investors might conflate the Chinese onshore corporate market, which we believe is expensive, with that of the Chinese offshore market, which already has experienced a substantial correction. 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, we believe the total return potential for U.S. dollar bonds offers a compelling investment opportunity at current levels.
1 Lippo Karawaci is listed as Theta Capital Pte, Ltd.
Rolling 12 Month Returns for the period ended 30 September 2018
|Matthews Asia Strategic Income Fund
I (Acc) (USD)
Markit iBoxx Asian Local Bond Index (USD)
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