China bond market stymied by index and ratings deficits

Foreign investor interest in the world's third-biggest bond market is growing. But that interest is capped until China develops a reliable credit market and is included in benchmark indices.
China bond market stymied by index and ratings deficits

Interest in the $9 trillion-plus Chinese onshore bond market is building but it's still early days for foreign investors. In the second of our two-part series, we look at other factors holding back international demand, in addition to currency-related concerns—namely, bond indexes and credit ratings.

Some of the most prominent index providers announced earlier this year that Chinese onshore bonds would be included for the first time. However, in the end they were only added to especially extended global indices, or emerging market/regional indices, rather than the most widely tracked benchmark global indices. 

On March 1, Bloomberg said it was launching two new indices: the Bloomberg Barclays Global Aggregate + China index and the Bloomberg Barclays Emerging Market Local Currency Government + China index.

Then on March 7 Citi said China was eligible for inclusion in its new World Government Bond Index-Extended (WGBI-Extended) index. The US bank also said China would join its EM Government Bond Index, Asian Government Bond Index, and Asia Pacific Government Bond Index.

Citi nonetheless said China would not for the time being be added to its main WGBI index, with a bank spokesperson reportedly citing the "higher acceptance thresholds" that apply to this index due to its greater significance to clients and the market.

As such, the world's third-largest bond market remains essentially one that is domestically driven and there seems to be little chance of that changing any time soon.
As Luke Spajic, head of portfolio management for emerging Asia at Pimco, told AsianInvestor, it will be a while before foreign investors are sufficiently comfortable with the asset class before the index providers think about including onshore Chinese bonds in their main benchmarks. 
As it is, Spajic’s China bond portfolio is mostly on China offshore US-dollar bonds.

Why the wait

It's not a chicken-and-egg scenario though; investor interest in the underlying market must precede index inclusion for the index to remain credible, even if inclusion potentially opens the door to yet more investor demand. 

Bloomberg opted to offer only extended versions of its indexes to accommodate onshore Chinese bonds, because investors have several concerns, Steve Berkley, global head of indices at Bloomberg, told AsianInvestor.

Investors want the ability to trade the renminbi freely and be assured that there will be no reversion to capital controls or market intervention when volatility appears in the market place, Berkley said.

China launched a stock market circuit-breaker mechanism in the first week of January 2016. The mechanism suspends trading on China's main stock markets if stocks fall 7%. That circuit-breaker was activated twice that week alone. On Thursday, it was triggered within half an hour of trading. 

Other factors include hedging for currency and duration exposures, as well as clear rules on taxes, plus a need for more convenient trading hours and more clearing banks in New York, Berkley added.

We created an option for investors to show what the global aggregate index will look like once China is fully included. This gives investors the chance to get comfortable with the index, and to look at the risk and return profiles, Berkley said.

So when the time comes, all we would need to do is to switch from the old (the current extended indices) to the new one, he said.

“We believe that over time and given the continuous changes that are coming out of China, China would be ultimately included in the main indices. It's a question of when rather than if,” Berkley said, without providing an estimate of when this might happen.

Credit rating

The lack of a credible credit ratings system is another drag on foreign investor involvement in the Chinese onshore bond market, because it holds back differentiation, not least in the non-government space.

“Institutional investors are more interested in the corporate bond market, which is less developed in China compared to international markets,” Ben Sy, Asia head of fixed income, FX and commodities at JP Morgan Private Bank, said.

Goldman Sachs estimates that corporate bonds accounted for just 31% of the Chinese onshore bond market at the end of 2016 -- with only about a tenth of these bonds issued by private enterprises and the rest coming from state-owned enterprises.

The rest of the market was comprised mainly of central government and municipal bonds (39%) and financial sector bonds (28%).

For this to change there needs to be greater variation across the credit spectrum, and that includes allowing weak companies to fail, Sy said.

Suzie Xie, Shanghai-based head of international business of Ping An Asset Management, agrees that a proper rating system would help foreign investors to better judge pricing and valuations, because in its stead they tend to stick with government and policy bank bonds and are potentially missing out on many high quality credits, she said.

Ping An AM has an internal rating system for Chinese onshore bonds, which follows international standards as adopted by Moody’s, Fitch, and S&P and hasn’t, Xie said, mistakenly assigned good ratings to bonds that eventually went into default.

Foreign investor access to domestic equity markets has occurred ahead of onshore bond markets, but over the longer term it is the bond market that could prove the greater draw, said AIA’s chief investment officer Mark Konyn, noting how insurers are constantly looking at ways to enhance yield and extend duration.

“Liberalisation of the capital account will create opportunities for insurers to participate in the bond market that aligns with these overall objectives,” Konyn said.

The story is based on comments AsianInvestor gathered for a feature article on China investment to be published in the upcoming August/September issue of magazine.

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