Matthews Asia Strategic Income Fund 1H15 Commentary

Matthews Asia Strategic Income Fund half yearly commentary for the period ended June 30, 2015.

For the first half of 2015, the Matthews Asia Strategic Income Fund returned 0.38% (Investor Class), while its benchmark, the HSBC Holdings plc (ADR) (NYSE:HSBC) (LON:HSBA) Asian Local Bond Index (ALBI) returned -0.44%. For the quarter ending June 30, the Fund returned -0.31% (Investor Class), while its benchmark returned -0.76%.

Matthews Asia Strategic Income Fund – Market Environment:

As we look back at the first half of 2015, we recall the headline events of the Greek default, the meteoric rise and fall of Chinese onshore equity markets, and the debt restructuring of Puerto Rico. While all these events caused short-term volatility, the real drivers of return in Asia bonds were the steady depreciation of Asian currencies and the steepening of yield curves.

Most Asian currencies continued to mildly depreciate, relative to the U.S. dollar, as the U.S. Federal Reserve is expected to raise interest rates while most Asian governments have been operating more in terms of monetary easing instead of tightening. The general steepening of yield curves should be framed more as normalizing from unusually flat curves at the end of 2014, resulting from global disinflation. The dovish bias of Asian central banks pushed short-dated yields (less than two years) lower while the normalization described caused medium and long-end yields to rise. Finally, credit spreads diverged. Investment-grade spreads widened by about 10 basis points (0.10%), in line with the mild rise one would expect from steepening yield curves. Conversely, non-investment grade spreads tightened by about 27 basis points (0.27%), driven largely by Chinese property bonds. In the first quarter, Chinese property developer Kaisa defaulted on its bonds. The market recovered as the market came to the conclusion that the Kaisa default was not contagious and home prices recovered from further central bank easing and loosening of home ownership regulations.

Matthews Asia Strategic Income Fund – Performance Contributors and Detractors:

The biggest positive contributors to performance for the first half of the year were our holdings in convertible and corporate bonds issued by Chinese companies. We made a deliberate reallocation away from local currency bonds into the convertible bonds. We found value in several convertibles of Chinese companies as Chinese equity markets rallied. This upside skew, combined with protected downside risk (as we targeted convertibles of solid companies with little leverage that were valued at or below their bond floor), provided attractive return vs. risk. Examples include our holdings of Ctrip.com and Biostime convertible bonds. The other category of outperformers included Chinese real estate holdings as our holdings recovered from the containment of the Kaisa default as well as the rise in property prices described previously.

The biggest detractors to performance were bonds of longest duration as the yield curves steepened. These hit our holdings of Yum! Brands, Inc. (NYSE:YUM)! Brands, a solid investment grade name. Since these are the longest bonds in our portfolio, with a maturity of 2043, these bonds sold off the most. Our holdings in Indonesian government bonds were also hurt from yield curve steepening as well as the 7% depreciation of the Indonesian rupiah over this period.

Matthews Asia Strategic Income Fund – Notable Portfolio Changes:

The most important change in our portfolio was our increased allocation into convertible bonds from local currency bonds. As mentioned above, we believed that convertibles represented the positive return potential given their upside optionality; protected downside when priced at or below the bond floor; and their low sensitivity to interest rates. We allocated away from local currency bonds as we expected Asian currencies to continue their gradual depreciation against the U.S. dollar.

Matthews Asia Strategic Income Fund – Outlook:

At the time of writing, the market is digesting two major uncertainties from two ancient civilizations: Greece and China. The Greek referendum has resulted in a “No” vote. This signals a fundamental structural shift in the Euro zone, throwing into question the sanctity of a monetary union and higher volatility for all risky assets. Because of the bi-modal nature of the vote, the market has not priced in the uncertainties and the potential secondary effects. Instead of this news dissipating in weeks, the volatility could endure for several quarters as a chain reaction unfolds. One thing we learned from the default of Lehman Brothers Holdings Inc Plan Trust (OTCMKTS:LEHMQ) is that it took more than two quarters for markets to bottom. Potential chain reactions might lead to the actual withdrawal of Greece from the Euro zone, which throws into question the potential for other countries to follow the same path.

While the fall of Chinese equities has certainly been sharp, the surprise has not been the fall but the policy response. Most investors understand that any market that rises so fast typically has the potential to fall twice as fast. More unexpected has been the rapid response of the Chinese government, which seems to signal that it is worried about the potential contagion resulting from an unwinding of assets, as providers of leverage may seize and sell collateral. This signals the vulnerability of a market in which the average participant is trading more on speculation than on fundamentals.

Given this highly uncertain context, we expect short-term returns to be driven by their historical