Asia's speculative-grade bond market is shrinking. Many Chinese developers have defaulted over the past two years. Issuance fell by nearly 90% in 2022, and another 40% last year. This is leading many investors to ask: what's in store?

S&P Global Ratings believes this market is transitioning. Local-currency bond markets are attracting more interest, and private credit is expanding briskly. We see this interest emerging in the U.S. and in Asia. Such trends are prompting institutional investors to take a broader view of Asian speculative-grade markets--one that incorporates U.S.-dollar bonds, local-currency debt, and private credit.

We draw our comments from an event we hosted on Feb. 21, 2024, titled, "Asia Corporate Virtual Conference 2024: China's New Year, Asia's New Cycle," and present the key takeaways in the frequently asked questions below.

Questions discussed include:

• Where is Asia's speculative-grade market headed?
• Will private credit become a key part of Asia speculative-grade?
• Will more firms raise private credit rather than issue bonds?
• How is the analytical approach for private credit different from bonds?
• Where will we see more bond issuance or private-credit activity?
• Will credit quality in Asia speculative-grade worsen or improve this year?

You can view a video replay of the event here.

Frequently Asked Questions

Where is Asia's speculative-grade market headed?

Manjesh Verma (BlackRock):  In Asia, investors have traditionally looked at credit through the lens of U.S.-dollar bonds. However, that market has dropped from a peak of US$1.4 trillion outstanding to about US$900 billion currently, following years of negative net issuance as more firms raise funds onshore.

The market is now at an inflection point and may need to expand. One way is to include local-currency bonds, which totals nearly US$8 trillion-equivalent outstanding in Asia. China accounts for most of this--about US$6 trillion. The rest includes Korea, Singapore, and India. These are also significant markets with decent growth potential.

Australia and Japan each have local-currency bond markets of about US$500 billion, which have not been tapped historically. Liquidity may have been an issue, but this will improve if more people get involved.

Ani Deshmukh (OMERS):  In Asia, the speculative-grade U.S. dollar bond market started scaling up about 15 years ago. The local-currency bond markets have also grown to be very large and are seeing more participation by offshore investors.

By comparison, private credit, as an asset class, was established much later in this region, with a few false starts over the past two decades. Now there seems to be critical mass--in terms of borrowers as well as lenders.

We look at markets both in terms of public credit and direct lending or private credit. Companies will grow, and their capital needs will evolve. We want to participate with them in more stages of their growth. It could be M&As, organic growth, or pre-IPO financing. Given the nature of our capital, which is all internal, the flexibility to be able to look at all these markets is valuable.

Will private credit become a key part of Asia speculative-grade?

Manjesh Verma (BlackRock):  Historically, Asia has been a very banks-dominated market, being about 80% funded by such lenders, and the rest through capital markets. At one end is traditional lending, involving the high-quality issuers that the banks lend to. At the other end are areas that are not being funded by traditional lenders. This is where special-situation funding comes in, with 15%-plus internal rates of return (IRR) types of deals.

In between there is a large area of mid-market lending, with IRR levels that are anywhere from high single digits to low- to mid- double digits. This is where a fair bit of industry development is starting to happen. A lot of investors are already involved, and more are getting involved.

Ani Deshmukh (OMERS):  For private credit to develop a broader footing in Asia-Pacific, a few requirements need to be met. First, there needs to be a dedicated pool of capital for this asset class for this region. This is happening now with local funds and global funds looking at this sector as an established asset class.

Second, borrowers' mentality needs to change. This is also happening. In the past, direct lending in Asia was largely for special situations, for example, turnaround or distressed financing. Now, the borrower base is maturing. Firms increasingly see direct lending as an ongoing financing channel. In the U.S., such lending has already become a permanent part of a lot of firms' balance sheets.

For borrowers, this is a way to engage a smaller set of lenders under a more flexible set of terms. For that, they may need to pay a bit more than they would issuing in the public bond markets.

Chart 1

Will more firms raise private credit rather than issue bonds?

Neel Gopalakrishnan (S&P Global Ratings):  In India, some of our rated issuers have used private credit, but mostly on a situational basis. For example, when their liquidity is under some stress, when traditional financing is not as accessible, or when they are not ready to issue bonds due to credit or market concerns. Vedanta Resources Ltd., for example, has done this multiple times. So have some firms in the renewables sector.

As these are stopgap measures, some issuers return to issuing bonds when market access improves. Some also use private credit as a form of asset-backed financing. For example, to raise shareholder loans through the collateralization of the firms' equity.

Private credit is often higher-cost and more structure- and covenant-heavy than bonds. Firms tend to prefer cheaper financing with fewer restrictions. This means private credit will be complementary to, rather than a replacement for, bonds.

Minh Hoang (S&P Global Ratings):  In Southeast Asia, there is demand for private credit, but it tends to operate where there is a gap in the market. For example, in countries where regulatory constraints make it difficult to lend to smaller firms. Flexibility to put in more collateral and structures can help in such situations.

Private lenders remain cautious in Asia, as weaker legal frameworks in some countries require them to view collateral in terms of what they could realistically claim in the event of default. As a result, many favor more legally developed markets, such as Australia, Hong Kong, and Singapore, over less-developed ones, such as Indonesia and Vietnam. This may also lead lenders to seek more equity-like returns, which compounds costs for borrowers.

In commodities, there is also scope for more private lending. For example, for years, the industry has asked who will step into the brown sectors to fill the void as traditional lenders and bond investors back away. Coal is the primary example of this as more firms face the risk of stranded assets.

How is the analytical approach for private credit different from bonds?

Manjesh Verma (BlackRock):  In general, fundamental analysis of private credit is the same as public bonds, but the volume of information is larger, because there is less margin for error. With less liquidity and longer commitments, one may not quickly get out of positions. The deals also involve more legal elements, and more engagement with the borrower and other counterparties.

Much of the information of the private deals are not accessible to public markets. This requires appropriate compliance procedures. It also means that one may not be able to finance such situations using regular public instruments.

Ani Deshmukh (OMERS):  Information asymmetry is an important aspect of private credit. Where information is not available, the level of diligence needs to be considerably higher, as the cost of surprises would be punitive. To manage this, one also needs to layer on structuring. This means private credit doesn't lend itself to suitcase banking. One needs to be on the ground. This requires more resources, but this is the investment needed for this asset class. Investors in return get structures and maintenance covenants not in public markets, as well as a seat at the table for growth and M&A financings in the region.

Where will we see more bond issuance or private-credit activity?

Manjesh Verma (BlackRock):  From an Asia-Pacific credit research perspective, Australia and India come to mind for public bonds as well as private credit. Singapore's local-currency bond market is relatively small; it can expand a bit more. Convertible bonds, especially in Japan, also look interesting. It's a large market that can add to the asset classes we look at.

Ani Deshmukh (OMERS):  Aside from India and Australia, China might become investable for more investors over the next two years, although a lot of things have to fall in place for that to happen. Japan and the Far East may also become interesting markets under the combination of nominal GDP growth and corporate reforms.

Chart 2

Neel Gopalakrishnan (S&P Global Ratings):  Indian issuers have become more disciplined, and don't have much need to issue U.S.-dollar bonds due to manageable funding needs and onshore liquidity. Regulators have loosened the spread caps on overseas bonds, but these restrictions still limit issuances to only those with reasonable credit profiles.

Also, issuers increasingly prefer to fund onshore, due to lower costs and deepening markets. For example, Nirma Ltd. has announced plans to issue a domestic bond of US$400 million-equivalent. While it is rated 'AA' locally, it would have been challenging for the firm a few years back to raise this much in the bond market. Today, they can do it without going offshore.

Minh Hoang (S&P Global Ratings):  In Indonesia, the investment pipeline is tremendous. This will drive funding needs. Also, restructurings of state-owned groups such as Pertamina (Persero) PT over the past few years are in part to create platforms for their subsidiaries to raise funds independently. We may see some of these entities come to the market now that the restructurings are completed.

Also, debt maturities are coming. For example, Indonesian property firms have some US$700 million of bonds maturing in 2025. Issuers are starting to plan for this. Lastly, in commodities, the banks increasingly face limitations in funding brown sectors, which may also drive firms in the sector to look at other options to diversify their funding sources.

Charles Chang (S&P Global Ratings):  Chinese issuers will remain cautious on capex as growth slows, leaving refinancing to drive issuing needs. In 2024, US$23 billion of bonds are coming due for industrials firms, US$22 billion for infrastructure, US$10 billion for consumers, and US$40 billion for real estate. Since most infrastructure bonds are investment grade and most property bonds are in distress, industrials and consumers will likely be the main issuing sectors.

Will the credit quality of Asia speculative-grade issuers worsen or improve this year?

Manjesh Verma (BlackRock):  We are reaching the peak of credit improvements, post pandemic. At this stage, credit profiles will stay in a holding pattern. Default rates will stay in check, especially outside China. Strength of the sovereigns and banks in Asia should also help, since it allows issuers to access onshore funding.

Neel Gopalakrishnan (S&P Global Ratings):  Within the region, India will remain one of the bright spots. Onshore liquidity has been very supportive, and most of our rated Indian firms will show high single-digit earnings growth this year. We expect their credit quality to consolidate after a sharp deleveraging starting in 2021. Once we have seen such debt reduction, further meaningful debt cuts will take time.

Charles Chang (S&P Global Ratings):  Credit quality in China should improve as the property sector stabilizes this year. We expect property sales to fall by 5% in 2024, versus the 6.5% decline in 2023 and a 26.7% drop in 2022. This should ease pressures on both consumption and growth. As a result, some sectors may do better than our forecasted 4.6% China GDP growth, including Macao gaming, electric vehicles, catering, and food and beverage.

Editor: Jasper Moiseiwitsch

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