Open up opportunities in the Chinese onshore corporate bond market EJINSIGHT
The Chinese bond market is now the second in the world after the United States. While the impressive growth of the Chinese offshore bond market is well noted, it is the spectacular rise of its onshore bond market that catches our attention. The fastest growing onshore corporate bonds; this is where we see exciting opportunities for investors looking for diversification and yield.
The Chinese onshore corporate bond market was relatively undeveloped until 2010, with Chinese companies traditionally relying on bank loans as their primary funding channel. Since then, as part of the reform and opening up of financial markets, Chinese regulators have issued various policies to reduce the economy’s dependence on the banking system.
In 2015, the China Securities Regulatory Commission relaxed the requirements for unlisted companies to issue bonds. This has led to a sharp increase in corporate bond issuance and a structural abandonment of bank financing.
In addition, strict regulations on shadow bank financing have also channeled part of the financing needs of companies into the bond market. As a result, the corporate bond sector has been the fastest growing segment of the onshore credit market in recent years.
Foreign participation in onshore corporate bonds remains limited
There has been a noticeable acceleration in the pace of foreign capital inflows over the past two years, but the increase in foreign holdings mainly concerns Treasury bonds and state-owned banks.
Participation in corporate bonds remained limited due to various challenges. For starters, the language barrier made it difficult to conduct fundamental credit analysis, especially during the pandemic. In addition, inconsistent rating systems and the lack of a significant presence of global rating agencies in China made it difficult to compare with standards used in developed markets.
At present, the nine national credit rating agencies and onshore ratings are generally biased towards the high end of the credit range, resulting in a lack of credit differentiation. That said, it should be noted that global rating agencies are entering this market. One of them received a rating license in 2020 and launched its first onshore ratings.
Rising corporate default rates since 2016 and uncertainties in the post-default process have also held back foreign interests. In addition, the low liquidity of corporate bonds (although improving) relative to Chinese government and bank bonds is another major challenge. This results in generally lower market turnover and wider bid-ask spreads. Trading in corporate bonds on the secondary market typically involves bonds issued by large central state-owned enterprises and local state-owned enterprises / LGFVs at the provincial level, while trading in bonds issued by private companies is less common as the bonds issued by private companies are less common. investors tend to hold them to maturity.
Are concerns about the increase in onshore defaults justified?
Of all the challenges, the most relevant is that of the land fault incidents in recent years. The first default of domestic corporate bonds occurred in 2014. Since then, the default rate has trended upward, with 184 new defaults in 2019 and 224 in 2020, for a default rate of 0.75%. and 1.04% respectively. However, we see this as part of the inevitable process towards a market-driven bond market, like the one experienced by developed capital markets years ago. A bond market that allows defaults by troubled issuers reiterates the need for active management with local expertise and credit research capacity.
Going forward, we expect the corporate default rate to remain at a reasonable level relative to global markets, with a combination of political support, steady economic growth and a more favorable investor structure.
Why we are positive in the onshore corporate bond market
The strong economic environment is the main incentive to invest in the Chinese corporate bond market. Although China’s economic growth has slowed, it will likely remain on a strong and healthy upward trajectory over the next 5-10 years. As one of the few major economies to have implemented a normal monetary policy, China has avoided resorting to a deluge of stimulus policies. As a result, China has maintained positive interest rates and a rising yield curve, which are conducive to sustainable economic and social development. In the long run, this helps to provide positive incentives to economic entities and to maintain the global competitiveness of yuan-denominated assets.
Chinese onshore bonds also offer good relative value compared to their offshore counterparts. The China Bond Corporate Bond AAA (5 year) index had a yield to maturity of 3.8% at the end of February, well above the 2.6% yield on investment grade offshore bonds. The gap has widened considerably since the second quarter of 2020, when the Chinese government began to tighten onshore monetary conditions. As the effect of policy normalization wears off, onshore bond yield premiums could eventually approach historical levels, meaning better returns for onshore bond investors.
Investors with credit selection capabilities will benefit
Inevitably, the series of defaults challenged investors’ assumption of an “implied guarantee” that Chinese authorities would save those who run into trouble. While these credit securities have negatively affected market sentiment, some insolvencies and defaults are part of a healthy and functioning market if wider contagion is contained. The recent wave of SOE bond defaults also reflects the authorities’ efforts to clean up “zombie companies” as part of China’s supply-side reforms, with structural deleveraging remaining the main policy focus. In fact, the increase in defaults shows the willingness of regulators to develop a mature financial market.
The recent rise in onshore defaults and the tightening of onshore liquidity in China have triggered bouts of volatility. This trend has drawn investors’ attention to fundamental analysis and credit selection and we view these episodes as opportunities for long-term investors with credit selection capabilities. The increasing differentiation of credit began to be reflected in bond prices.
All in all, it should be noted that this is not the first time that shore faults have caused concern and likely will not be the last. Ultimately, the Chinese government has the political will and the decision-making ability to bring the market back to calmer waters. Past experience has shown its ability to contain systemic risk and maintain overall financial stability.
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