Shaping up for China's onshore bond bonanza

In the second of a two-part article on China's debt markets, fixed income managers outline the opportunities they see and how to play them.
Shaping up for China's onshore bond bonanza

Fixed income fund managers are eagerly anticipating the further opening of China’s bond market, due to the depth and breadth of securities that will be on offer, and are making preparations for how they will play these opportunities.

Speaking on a panel discussion at a recent forum hosted by the Hong Kong Investment Funds Association (HKIFA), Bryan Collins, portfolio manager for Fidelity Worldwide Investment in Hong Kong, noted the mainland bond market could well double in size to more than $10 trillion in the next decade.

The panellists discussed the immense growth potential of the market in light of RMB internationalisation efforts such as the yuan being included in the Interational Monetary Fund's basket of currencies with special drawing rights, as reported.

And the managers on stage said their buyside firms were in the process of increasing their credit research capabilities focused on China in expectation of the market's growth.

Stephen Chang, head of Asian fixed income at JP Morgan Asset Management, said: “We are very much looking forward to the growth of China’s onshore bond market. All of us [on stage] will be setting up our research and investment capabilities to make sure we can handle this size of market.”

Similarly Fidelity's Collins said the US fund house was putting more resources into onshore credit research in China. Yet at the same time he noted the homogeneous nature of onshore credit ratings largely due to lack of transparency and granularity meant it was relatively easy to find better quality credits right now.

The forum had heard that over 30% of China's corporate bond market was rated AAA by the three main onshore ratings agencies, China Cheng Xin International (CCXI), China Lianhe Credit Rating and Dagong Global Credit Rating.

Indeed, Warut Promboon, chief rating officer for Dagong Global Credit Rating Company (HK), pointed to lack of differentiation between rated credits in China. "The ceiling is quite low," he reflected.

However, Collins suggested this lack of dispersion in the pricing of credits with similar tenors meant investors could pick and choose higher-quality issuers.

“Given there is no price differential, you are spoilt for choice; you can start eliminating names that have poor disclosure or weak bottom-up fundamentals and you can start focusing on better-quality credits and provincial governments,” he explained.

He said it was only when the market started to mature and expand that investors would see greater dispersion in credit quality and differentiation in pricing, spreads and yields. “Then it will become trickier to differentiate, but for now it is relatively easy,” Collins stated.

Chang noted that defaults were starting to occur onshore, with several examples of state-owned enterprises not paying on time, getting into difficulty and requiring intervention. The way the Chinese authorities resolve this type of situation will set precedents for pricing of these credits, he said.

That said, a handful of default cases from 1,000 onshore issuers would mean the default ratio remaining well below international norms, added Chang.

In terms of specific opportunities, Ben Yuen, head of fixed income at BoC (HK) Asset Management, pointed to developments in China’s fledgling municipal bond market this year.

He noted that initially there had been little difference between yields of munis and government bonds, but that the spread had since risen to about 50 basis points (bp). He estimated that the yield differentiation between high- and low-quality muni bonds stood at about 100bp.

“So the market might now start to price in risk premium according to the different quality of the credits,” said Yuen. “Muni bonds should be a very good market for foreign investors.”

However, he said there was insufficient data disclosure on local governments, making it difficult to determine appropriate risk premia for different muni bonds.

Promboon of Dagong agreed that the transparency of China’s onshore fixed income market was “as murky as the Beijing air”, but did say that it was improving.

He framed the challenges as transparency of both regulations and data in China, saying it was hard to find good sell-side research. The language used in research was often part of the problem, he said, with analysts reluctant to be too direct in their criticism.

But Promboon noted that, unlike in India, things could happen very quickly in China, with investors, issuers and the regulator working together.

A member of the audience asked whether short-duration bonds were the best options for investors, given low liquidity in long-duration issues and almost no term premium.

With onshore deposit rates of 1.5% and 10-year bonds at 3%, said Collins, "that sort of curve steepness is better than you see in other parts of the world".

He added that the onshore bond curve could even invert, which would make long-duration assets relatively attractive given continued onshore monetary easing in the short term. "I do not think China is a short at this stage," he said.

But he acknowledged that there were some stretched valuations in the corporate credit market. "Maybe you could short credit."

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