Matthews Asia Credit Opportunities Fund


Period ended 31 March 2020

For the quarter ending 31 March 2020, the Matthews Asia Credit Opportunities Fund returned -13.60% while its benchmark, the J.P. Morgan Asia Credit Index, returned -3.60%.
 

Market Environment:

2020 started on a seemingly good note, with the U.S. and China signing Phase 1 of the trade deal on January 15th. Shortly thereafter, though, China locked down the city of Wuhan to try to slow the spread of the novel coronavirus. The virus would soon spread through Asia and across the world, leaving public health officials, policymakers and central banks scrambling to react to both the health care and economic challenges that treatment and containment presented. Despite the fact that China was the epicenter of the outbreak, Asian high yield credit spreads remained steady in the 500-550 basis point (5.00-5.50%) range until late February. As the coronavirus spread through the U.S. and Europe, fixed income, equity and commodity markets around the world came under pressure. In Asia, high yield credit spreads nearly doubled in a one month period from late February to late March, peaking at 1,040 basis points (10.40%) on March 23, before recovering into month end.
  
Many countries around the world have aggressively pursued containment policies, and policymakers have responded to the sudden halt in economic activity with bold fiscal and monetary measures. The U.S. Federal Reserve has committed to using its tools to steady a variety of markets, including Treasuries, investment grade corporates, mortgages and municipal bonds.  Asian policymakers have responded aggressively, particularly in China, where banks have been asked to roll over loans rather than force companies to repay or refinance their debt. Our exposure across the portfolio to companies driven by domestic consumption and services has provided some insulation relative to companies in industries more exposed to foreign demand.
 
Another key contributor to the drastic fall in price of credit has to do with the embedded optionality of the bonds. Because most high yield bonds have an embedded option that enables issuers to call or reset their debt, much of the price depreciation has to do with credit duration extension. As credit risks rose, securities extended in credit duration from trading to the next call/reset date to trading to their maturity date, necessitating a step down in the price of their bonds in order to offer not only a higher spread, but also to a longer maturity date. 

Performance Contributors and Detractors:

During the first quarter, amongst the biggest detractors to Fund performance were our holdings in the frontier sovereigns of Sri Lanka and Pakistan, and Indika Energy in Indonesia. Frontier sovereigns like Sri Lanka and Pakistan are usually more exposed to external shocks than developed and emerging countries, and policymakers have more limited scope to provide fiscal and monetary support to their domestic economies. Because of this, the coronavirus slowdown hit the sovereign bonds of Sri Lanka and Pakistan particularly hard. Indonesian credits, including the coal mining company Indika Energy, were hit hard during the sell-off. Indika suffered both because of the general risk-off environment and the fall in commodity prices.
 
On the other hand, our holdings in the bonds of iQIYI and Sino Ocean in China and Debt and Asset Trading in Vietnam were amongst the biggest contributors to Fund performance. The convertible bonds of iQIYI, an online entertainment service in China, performed well as the underlying shares rallied on expectations for robust subscriber growth during China's lockdown. Sino Ocean is a state-owned property developer in China, and its perpetual bonds performed well despite the market volatility. Debt and Asset Trading Corp. is a wholly-owned subsidiary of Vietnam's Ministry of Finance, and their bonds provide an attractive spread pickup to sovereign bonds.
 

Notable Portfolio Changes:

We made a handful of changes to the portfolio in the first quarter.  We added the convertible bonds of Bosideng Group, a down jacket brand in China, and the perpetual bonds of Jollibee Worldwide, a restaurant chain in the Philippines.  We expect both bonds to perform well once the current crisis subsides and economic activity normalizes. We also added to existing holdings across the region, including in high-quality Chinese companies like Far East Horizon, Luye Pharma and Sino Ocean.
 
Early in the quarter, we exited several bonds in order to take profits. We exited the convertible bonds of iQIYI, an online video platform in China, which had reached our price target. We also exited the perpetual bonds of ANZ Bank and Standard Chartered, as well as the bonds of Indonesia Asahan Aluminum, an Indonesian state-owned company.

Outlook:

At the current implied default rates of mid-teens, we believe there is significant value in Asian credits that will weather the storm and avoid defaulting. As of March 31, 2020, Asia high yield spreads are at 958 basis points (9.58%). At the peak of the global financial crisis in the fourth quarter of 2008, Asia high yield spreads widened to about 1, 000 basis points (10.0%). Assuming historical recoveries of 45 cents on the dollar, current spreads are impounding about 15% probability of default already. With rolling 12 month default rates at 2.43% as of March 31, 2020 and a portfolio of credits which we do not believe will default, we believe that current prices could represent a once in a decade entry point.
 
One of the most vulnerable segments is the frontier sovereigns, which have rolling maturities that need a functioning capital market to refinance, including countries like Pakistan and Sri Lanka. Fortunately, Pakistan has already secured financing from multilateral lenders to cover maturities for the next few years. Sri Lanka has announced additional financing from China and its resolve to honor its debt obligations.
 
We continue to assess relative value across credits in an effort to lock in attractive yields while seeking to upgrade the portfolio. As credit spreads stabilize and recover, we believe our bonds will appreciate in price from the shortening of credit duration. We expect that this will reverse the credit duration extension that impacted all high yield debt previously described.  As Asian economies recover from trough economic activity, we believe that our portfolio has significant positive skew and upside returns potential. While past performance is not indicative of future results, history has shown that any one year period can have outsized returns, both positive and negative. Asia high yield experienced a drawdown of -25% during the global financial crisis, but also gained 54% in the year following the crisis.


Rolling 12 Month Returns for the period ended 31 March 2020
Matthews Asia Credit Opportunities Fund 2020 2019 2018 2017 2016
I (Dist) (USD) -7.33% 1.36% 6.09% 9.66% n.a.
J.P. Morgan Asia Credit Index (USD) 2.34% 5.53% 1.73% 4.80% n.a.
I (Dist) (GBP) -1.88% 9.03% -5.90% 26.41% n.a.
J.P. Morgan Asia Credit Index (GBP) 7.55% 13.61% -9.32% 20.46% 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 Distribution 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