For the quarter ending September 30, 2022, the Matthews Asia Credit Opportunities Fund returned -2.90% (Investor Class) and -2.82% (Institutional Class), while its benchmark, the J.P. Morgan Asia Credit Index returned -3.51%. 

Market Environment:

Along with most asset classes globally, Asia credit saw material declines in first nine months of 2022. It has been a tough market, marked by price declines driven by both credit spread widening and rising U.S. interest rates.

The U.S. dollar-denominated Asia credit market continues to grapple with rising defaults and ongoing uncertainly. We continue to see a steady wave of defaults driven by the China property sector.  The Asia high yield default rate hit a multi-year high of 38.7% (by amount) in the third quarter that includes the default US$53.6 billion of China high yield property bonds year-to-date. Asia high yield spreads ended the third quarter at 1,163 basis points (10.63%), the highest level since inception of the J.P. Morgan Asia Credit Index. Asia investment grade spreads widened just 2 basis points (0.02%) to 208 basis points (2.08%) at the end of September, though the substantial rise in U.S. interest rates led to a loss in the quarter.

The Asia credit market this year has been dominated by China’s zero-COVID policy and its consequences on the economy, along with the slowdown in the property sector.  The start-and-stop quarantines that have paralyzed mobility in much of China sterilized much of the macro policy designed to ease credit conditions and reaccelerate the economy.  Within this macro backdrop, several sub-investment grade property developers in China have been unable to refinance their maturities as there was no marginal buyer willing to lend. With the lack of credit, liquidity and workers, construction remains at a standstill, resulting in continued deterioration in the sector.  In the U.S., inflation continues to run significantly above the Federal Reserve’s mandate, with investors pricing in a higher likelihood of the Fed having to slam the brakes to slay the inflation dragon at the expense of economy.  Oil and food prices remain elevated given the ongoing conflict in Ukraine, though thankfully many commodities have fallen from their peak levels. 

Performance Contributors and Detractors:

Among the top contributors to returns were our busted convertible bonds. These include Chinese pharmaceutical company Luye Pharma, Chinese video content maker and video platform operator iQiyi  and Australian cloud accounting software company Xero.

Among the biggest detractors to returns were our real estate investments.  These include Sino Ocean and China SCE, both Chinese property developers, and Lippo Karawaci, an Indonesian property developer.  Sino Ocean and China SCE are facing tight liquidity pressure and slow presales, like many companies in the China property sector.  Lippo Karawaci’s performance has been solid, but its bonds fell as the market repriced.

Notable Portfolio Changes:

In the third quarter, we initiated two new positions, both in contingent convertible bank bonds.  We bought the bonds of HSBC Bank and Krung Thai Bank as both bonds had fallen and offered attractive relative value.  In general, we believe that bonds issued by investment grade-rated banks operating in investment grade-rated companies offer attractive yields with limited volatility in the current environment.

We exited a handful of positions in the quarter including   our position in Luye Pharma, when the bonds became puttable back to the company.  We also exited our position in Indika Energy when the company unexpectedly held a tender offer for their bonds, which we believe was done at an attractive premium. 

Outlook:

By all measures, Asia credit has priced in much of the risks and uncertainties in the market today. With credit spreads at historic highs, they have already baked in expected defaults across much of the sub-investment grade Chinese real estate sector.  While we believe defaults are likely to continue, we expect the overwhelming majority of restructurings to be amend and extend exercises which result in an extension of the maturity, but no haircut in principal so that bondholders should ultimately see a recovery of 100% of their principal.  The other component to Asia credit returns is U.S. interest rates, which unfortunately have more risks of rising than falling.  We have seen high volatility driven by waning or waxing inflation and the market’s expectation of the Fed’s ability to tame the U.S.’s stubborn and persistent inflation. With the yield curve pricing in continued rate hikes at upcoming Fed meetings, the market is increasingly pricing in a challenging inflation picture that would likely land the U.S. into a recession in the coming year.  With the persistence of inflation and defaults, buyers have been waiting on the sidelines, reluctant to catch a falling knife. However, as any of the storm clouds we outline dissipate, we expect the patient marginal buyer to finally step in to take advantage of depressed valuations to reap price appreciation and potential outsized returns in the coming years.

View the Fund’s top 10 holdings as of September 30, 2022. Current and future holdings are subject to change and risk.

Average Annual Total Returns - MCRDX as of 09/30/2022