Opportunities in China’s Bond Market
China’s economic activity has bounced back from the global pandemic earlier and stronger than elsewhere and bond yields are “normal” relative to other markets. In this Q&A, Teresa Kong, CFA, provides an update on China’s bond market as well as the risks and opportunities in the Chinese fixed income market—the second largest in the world.
Why should global investors consider Chinese debt?
In our textbooks, U.S. treasuries were considered to be the risk-free security. But in today’s environment, I would argue that “risk-free” U.S. treasury bonds are indeed risky. Prices are more likely to fall as interest rates rise as the U.S. continues on a recovery path out of the pandemic-induced recession. Historically, Treasury bonds have been among the best hedges to U.S. equities as major risk off events cause investors to sell equities and buy safe-haven assets like US Treasuries. However, price appreciation in US Treasuries will likely be muted with the Fed committed to holding rates above zero, so the diversification benefit from appreciating Treasury bonds may be capped. Within that context, the risk-return calculus for Chinese debt is quite attractive, in my view.
So yields are relatively high in the Chinese bond market?
The onshore China bond market is offering yields of 3% -4% for a 10- 30 year long government bond. For those willing to take on investment grade corporate credit risk, the yield can be upwards of 4.5%. But yield is just one component of risk as I explained.
How do you think about risk and return in China’s onshore market?
The primary components of risk for Chinese debt are rates, currency and credit. In terms of credit, China has an A1/A+/A+ rating from the three major international rating agencies. Second, interest rates have more room to fall than to rise in China as inflation remains subdued. Finally, the Chinese renminbi might continue on its appreciation path relative to the U.S. dollar. As an example, if we start with a yield of 3%-4% for a China government bond and add potential 1%-2% appreciation and 1% for credit spread for an investment grade corporate, that could potentially mean 5 -7%total return for a U.S. dollar-based investor.
Why is ownership so low among international investors?
Ownership is still relatively low, around 3% percent of the overall bond market, and around 9% percent for government bonds. Ownership has been historically low because of limited access and because Chinese bonds have not historically been part of global bond indices. But as the Chinese government has liberalized access, the global bond indices have begun to include China bonds into their indices. As we speak, China is about 6% of the Bloomberg Barclays Global Aggregate Index, and is slated to be included in the FTSE Russell Global Bond Index in October 2021. As a result, we would expect international investor ownership of Chinese bonds to rise in the coming years.
Where do you see the biggest opportunities in Chinese fixed income?
We see the biggest opportunities for Chinese fixed income in both the onshore as well as the offshore bond market. The Matthews Asia Total Return Bond Strategy owns both onshore and offshore corporate Chinese bonds, and we analyze corporate credit as well as currency risk. In the onshore market, taking on the blue chip credit risk provides an opportunity to potentially pick up extra basis points on top of the yield we would get from China government bonds. We also find offshore, or the U.S. dollar-denominated non-investment grade bonds of Chinese corporates as similarly attractive.
Speaking of risks and volatility, what is the default rate of the Chinese bond market?
The default rate for the Chinese bond market remains low compared to the U.S. and even other Asian countries. By our estimates, the default rate for 2020 stood at ~0.8%. In our view, the relatively low default rate can be attributed to the following reasons:
- Companies who issue bonds in China tend to be the best in their respective industries and is not representative of the entire Chinese economy. As such there is a sampling bias.
- Large presence of various State Owned Enterprises (SOEs) which enjoy relatively easy access to liquidity. The bond market is often just one of the many channels of liquidity the SOEs have access to, reducing the likelihood of default.
- Government support of key sectors such as banking which result in very low default rate of banks
Overall, the default rate for the China bond market is low for several structural reasons. However, over time, we expect some of the structural forces like government support of certain sectors or companies to diminish, paving the way for default rate to gradually increase. Better pricing of risk should be welcomed by investors, but I believe it will remain crucial for investors to invest in the Chinese bond market with an investment manager with proven expertise and experience in China.
Can we trust the local market ratings? Why are there so many domestic rated AAA companies?
The Chinese domestic rating are based on a different rating scale than international ratings agencies and uses existing domestic default data. Since default rates have been low, most companies get an AA or above domestic rating. With international rating agencies entering the domestic market and starting to cover more companies, we expect ratings to gradually be calibrated closer to an international rating scale with longer histories for companies with similar credit metrics. This difference in ratings underscores the difficulty in credit differentiation in China as international investors often cannot rely on domestic ratings. We believe this highlights another reason for investors to invest with experienced fixed income managers.
Are you concerned about corporate governance for companies in China?
We take into account corporate governance along with a whole host of other factors when we make our investment decisions. We have a special credit analysis framework that we utilize to determine credit worthiness of Chinese companies. We believe this allows us to better distinguish companies, identify opportunities in the market and seek to generate alpha. Fixed income entails assessing and mitigating risk, so evaluating the corporate governance of issuers is an essential part of our investment process.
Are you concerned about currency risk associated with the Chinese Yuan (CNY) and the ability to remit funds during times of stress?
The CNY (onshore currency) is a managed floating currency. In general, the currency tends to exhibit low volatility relative to a fully floating currency such as the euro. During times of financial stress and increased outflows, we have seen the government take various steps at controlling capital outflows. However, we have not to this point observed any controls being placed in the Bond Connect channel or the China Interbank Bond Market (CIBM) Direct channel. The two channels represent the main conduit through which foreign investors get access to the Chinese bond market.
How do I get access to the Chinese bond market?
There are two primary ways investors can gain direct access to the Chinese bond market: Bond Connect or CIBM Direct. Both channels allow foreign investors to access the China Interbank Bond Market (CIBM). However, investors have to go through an involved application process that can be daunting for first time investors in China. As such, we believe the best way to gain access is to invest with a manager who already has access.
Can you summarize the main reasons to own Chinese bonds?
The main reasons are threefold:
- Extra yield—In today’s environment with many of the major economies operating in zero or close to zero interest rates, China is one of the few major economies that still offer yields significantly above zero
- Diversification—Chinese bond market returns have low correlation with other asset classes, making it very useful as an diversification asset in our view
- Relatively low currency volatility—The renminbi offers significantly lower volatility than currencies of other major economies making the volatility-adjusted unhedged total return attractive
Fixed income investments are subject to additional risks, including, but not limited to, interest rate, credit and inflation risks. Investing in emerging markets involves different and greater risks, as these countries are substantially smaller, less liquid and more volatile than securities markets in more developed markets.
AAA ratings are issued to investment-grade debt that has a high level of creditworthiness with the strongest capacity to repay investors.