Date
19 October 2018
One of the key purposes of the bond market in China is to provide liquidity to finance government projects for the long term. Photo: Bloomberg
One of the key purposes of the bond market in China is to provide liquidity to finance government projects for the long term. Photo: Bloomberg

Unlocking value in onshore China bonds

China’s US$11.4 trillion bond market is the third-largest in the world but remains an unchartered territory for global investors. Many have viewed this market as a vast investment opportunity while some still see it as a minefield.

Admittedly, these are trying times for the Chinese bond market. Regulatory tightening and curbs on shadow financing, while much-lauded moves, are taking a toll on funding among private companies. Credit flows have slowed and surging corporate borrowing costs have made it harder to refinance debts. And rising corporate defaults can rattle investors.

But we beg to differ. Now is an opportune time to add China in global portfolios.

Too large to ignore

Given the size of the domestic bond market and the scale of its growing economy, international investors want to be ‘in’ on China.

Interestingly, China remains a relatively closed market despite being the world’s second largest economy. The domestic debt market is underdeveloped and foreign ownership is extremely low. But this is changing.

Already, the Bloomberg-Barclays Global Aggregate Index has decided to include renminbi-denominated government and policy bank securities starting April 2019, after the Chinese government implements several planned operational enhancements.

RMB-denominated bonds will be the fourth-largest component in the Global Aggregate Index when fully accounted for, after the US dollar, euro and Japanese yen. It would include 386 Chinese securities, representing 5.49 percent of a US$53.73 trillion index, as of 31 January 2018. With this inclusion, other major indices will likely follow, boosting the market’s prospects.

Moreover, China’s bond market has historically been less correlated to other emerging-market local currency markets as well as developed market core rates, providing potential good diversification benefits for international investors.

And the Chinese market is also unique in its low dependency on external funding. China’s external debt stood at US$1.68 trillion as of end-2017 and the financial risk is controllable. With US$3.22 trillion in foreign reserves, the government balance sheet is healthy.

Sources of liquidity

The Chinese government is a one-party political system which dominates all aspects of policy-making. And Chinese policymakers typically think long-term. One of the key purposes of the bond market in China is to provide liquidity to finance government projects for the long term. That hasn’t changed. The market has been expanded to attract foreign capital for the development of such projects.

Sovereign and quasi-government bonds are investors’ top targets in China. State entities executing national policies or policy banks that finance national development projects are attractive options for RMB bond investors. For example, China Development Bank, the nation’s biggest policy bank, issued 7.9 trillion yuan of short, medium, long and super long-term bonds in 2016. Recent bond issues cover funding for green projects and those under China’s ‘Belt and Road Initiative’.

Quasi-state enterprises are also viable options, including those that operate the national grid and major oil and gas fields, and are involved in hydropower generation. Higher-rated companies or those with an international investment-grade rating are also on investors’ radar.

As a bond investor in China, credit analysis of the bond issuer and their priorities is crucial. China still has much ground to cover in terms of good corporate governance, financial transparency and investor protection. We prioritize first-hand research, visiting Chinese companies to assess the quality and fundamentals of the business as well as conduct due diligence on management including speaking to senior executives and government officials directly.

Diverging policies

Interestingly, the bond yields of US and Chinese bonds are starting to converge with diverging monetary policies across the two economies.

The US Federal Reserve is on track to raise interest rates while signs of corporate stress emerging in the Chinese economy may force policymakers to shift away from its current ‘neutral-to-tight’ monetary policy stance.

Already, twelve onshore bond issuers have defaulted on 21 bonds with a total principal amount of 20.2 billion yuan, as of June 4, 2018, according to Fitch Ratings. And the first bond default by a local government financing vehicle is likely this year. Still, such non-payment may help allocate resources more appropriately between state-owned enterprises and private companies.

Policymakers in China will have to step in at some point to soften leverage curbs and ease monetary policy. A targeted reserve requirement ratio cut will be likely, which will encourage banks to lend to the private sector. Regulators may also allow issuance of bonds beyond the purpose of just refinancing maturing bonds.

With that in mind, we are keeping our focus on higher-rated companies, or those with an international investment-grade rating. Their yields on the benchmark indices remain relatively attractive. And their spread over sovereign bonds should compress when the government implements easing measures later this year.

The yield for the CITI World Government Bond Index (WGBI) Global stood at 1.72 percent and the Global Aggregate Index was at 1.96 percent as of end-May 2018. The CITI WGBI-China 1-10 Year, which includes 98 Chinese securities, was 3.45 percent over the same period.

Overall, with highly-competitive yields, a market where the interest rate trajectory is trending down, a low correlation to other markets as well as exposure to the Chinese economy, we certainly see an investment case where onshore China bonds can potentially reap handsome gains and more importantly, improve the risk-return profile of investors’ portfolios.

– Contact us at [email protected]

RC

Investment Manager – Asia Fixed Income, Aberdeen Standard Investments

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