An improving global economy and expectations of tighter monetary policy may trigger volatility in bond markets. How can fixed-income investors dampen the effect on their portfolios? One answer may be US-dollar Asian corporate bonds.

The macroeconomic backdrop is improving, and US interest rates are rising. This means that fixed-income investors could eventually be enjoying more income in their portfolios. Before that, unfortunately, they face the prospect of a rise in market rates which would cause bonds to return to lower, more normal valuations.

In this environment, fixed-income investors may be especially interested in adding ballast to their portfolios with an allocation that might earn reasonable portfolio income without too much additional volatility. Such an opportunity exists—in the US dollar-denominated Asian credit market.

Stability, Diversification and Growth

Part of the market’s appeal is its underlying economic strength. Compared with the rest of the world, including many developed markets, Asia is growing more quickly and has a more stable banking system and significantly healthier current account balances (Display 1).

Asian Credit

But what about the commonly perceived risk associated with investing in Asia today: China’s economic slowdown and its potential impact on the region, given the country’s dominance? Our economic research helps to put such risks in perspective.

We still forecast China’s GDP to grow well above 5% in the next two to five years. That’s much stronger growth than in other large economies around the world. Many Asian nations also stand to benefit from China’s ambitious “One Belt, One Road” infrastructure initiative.

But China’s influence over other Asian countries isn’t uniform. While this alone is a considerable source of diversification for investors in the region, many countries are also in different stages of their credit and economic cycles and overall development. India and Indonesia, for example, are experiencing economic recovery while Hong Kong and the Philippines are continuing to expand. More developed markets such as Hong Kong, Korea and Singapore offer a degree of stability that can offset more volatile opportunities that our research uncovers in frontier markets such as Mongolia, Sri Lanka, Vietnam and Pakistan.

The growth and diversity in the region’s economies translate to the Asian credit market, where outstanding issuance increased from less than US$100 billion in 2000 to nearly US$800 billion across various countries and sectors by the end of 2016.

Attractive Yield with Low Volatility

The Asian credit market has delivered strong returns over the last three years, and while it’s true that absolute yields have fallen, the J.P. Morgan Asia Credit Index is still offering a 111-basis-point yield pickup over the Bloomberg Barclays Global Aggregate Corporate Index.

Robust fundamentals and positive technical factors—including increasing support for the market among Asian investors—are reflected in the Asia credit market’s performance: its returns are not only attractive on an absolute basis, they are also superior to those of global investment-grade corporate bonds and emerging-market credit when volatility is taken into account (Display 2).

Asian Credit

While US-dollar Asian credit won’t be immune from the effects of higher US interest rates, the sector should be relatively resilient thanks to its lower duration (or sensitivity to changes in interest rates). For example, the average duration for the J.P. Morgan Asia Credit Investment Grade Index is 5.2 compared to 7.2 for the Bloomberg Barclays US Investment Grade Index; the average duration on J.P. Morgan Asia Credit High Yield Index is 3.2 compared to 3.9 for the Bloomberg Barclays US High Yield Index.

Balancing Risk and Return

How can investors take advantage of this opportunity? Focusing either on investment-grade or high-yield credits would expose them to either too little yield, too much duration risk or too much credit risk, in our view. We believe a better way lies in actively allocating risks across the entire spectrum of the US-dollar Asian credit market, supported by strong research.

This requires a flexible approach and comprehensive macro and credit research capabilities. For example, even though China’s overall economy has slowed down, good credit research will identify sectors and credits in the country that can outperform. It can help investors preserve their principal by avoiding investing in corporates at risk of default, and it can also contribute to capital appreciation by capturing market dislocations triggered by credit events.

Over time, we think this approach to the US-dollar Asian credit market offers one of the best prospects for capturing stability and income in the current global credit market environment.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Article by Jenny Zeng, Alliance Bernstein