The following article first appeared in the July 2008 edition of AsianInvestor magazine. Each month we offer online a feature from the magazine. To subscribe for more in-depth industry analysis that you canÆt find on our website, please send an e-mail to: [email protected]

Institutional investors in China just canÆt get enough of fixed income securities û literally.

Global fund managers and investment bankers spend a lot of time tracking Chinese institutional investorsÆ vast pools of assets. But for Chinese investors, while the opportunity to diversify overseas is important, itÆs not their main focus. Nor do they share fund managersÆ delight at their rapidly accumulating wealth. Domestic instruments donÆt meet their needs, particularly for pension funds or life insurance companies with long liabilities, whose officers are working against the time-bomb of Chinese demographics.

And the recent hike in inflation only adds to their woes.

Where to find yields to match ChinaÆs exploding liabilities is a daunting question for insurers: current regulation dictates 80% of assets need to be held in fixed-income securities. In the perfect world, a booming A-share market and QDII investments should fix all their funding needs, yet bearish outlooks for equity back home and overseas have brought insurers back to earth, to focus on domestic fixed income.

Liu Lefei, CIO at China Life Insurance, says his firm needs more longer-dated securities but the market is not meeting his investment needs. ChinaÆs fixed-income universe needs to change.

Capital-market reforms in the past 10 years have brought about much-needed changes in the equity market but have left the bond universe behind. ItÆs not that bonds do not exist in China: bonds were re-introduced to the market in 1981 by Deng XiaopingÆs early administration, 10 years before there was even a bourse in Shenzhen for equity listing.

They are a highly important asset class. Yet 10 years on, the bond market is still left in fragmented state.

Overall, the market lacks scale and variety of instrument, which means it doesnÆt have a proper yield curve.

Liu Xi, director for fixed income at Harvest Fund Management in Beijing, says in the fund management sector, the lack of long-dated instruments means the typical bond portfolio actually yields lower than benchmark deposit rates. Managers looking for yield often seek them in equity-linked components such as convertible bonds. These instruments are popular among fund managers due to rewarding yields from pre-IPO investments.

Fund managers are, however, marginal players. Banks are the dominant buyers, often trading in ticket sizes that dwarf a fund houseÆs entire portfolio. In such an environment, new purchases are usually held to maturity, stunting any secondary market or liquidity.

ChinaÆs bond market is still highly fragmented in its structure, making it difficult for investors to access liquidity. The two key trading platforms are the inter-bank market and the exchanges. Sovereign credits, quasi-sovereigns and financial bonds make up the bulk of transactions in the inter-bank market. It is in the exchanges, meanwhile, where the headline-grabbing corporate issues are traded.

The two markets run completely independently of one another, and are subject to different regulations. The PeopleÆs Bank of China oversees the larger and more dominant inter-bank market. It has the power to set interest rates for all new issues (so it is a stretch to even call it a æmarketÆ). The more reform-minded China Securities Regulatory Commission runs the exchange market, where the price mechanism is allowed to function. It is no surprise the two regulatorsÆ rulings sometimes overlap with one another, creating uncertainty in bond-market outlooks.

Exactly a year ago, the CSRC instigated reforms to streamline regulation for corporate issues. The original, onerous requirements for companies seeking to issue were removed. Bank guarantees and approval from the National Development & Reform Committee are no longer necessary. So long as a company is a listed entity, and has a credit rating from a recognized agency, it can issue bonds.

The investor community has celebrated this reform as among the most important milestones in ChinaÆs development of its capital markets. Foreigners are also excited, seeing the bond market as a way to invest in ChinaÆs growth story (and its appreciating currency).

Issuers û or, rather, potential issuers û didnÆt share the enthusiasm, however. Most listed companies are state-owned enterprises. Their managers view a stock listing as the path to glory, particularly when valuations were high (and when the stock belonged to the government, not them). And should the company actually need to borrow money, why not simply approach your friendly bank loan officer? When the banks are simply bursting with spare liquidity, theyÆre not going to ask for a bond covenant or stick their nose into how the company actually uses the proceeds of the loan.

This mentality began to change after the A-share market peaked in October 2007. The stock market no longer looks so glorious. And the central bank continues to battle inflation by restricting banksÆ ability to lend. At the same time, the popularity of the stock market in 2006 and 2007 has made more company officials shareholders themselves, who are no longer so keen to dilute their firmÆs equity.

Zhang Wei, senior investment consultant at Watson Wyatt in Beijing, says at this point in time, ChinaÆs capital market is at real risk of failing to match up the countryÆs economic growth û but that things may be changing. There is still too much liquidity caught in ChinaÆs financial system but many corporations still fail to access capital. The constant warnings about diversifying sources of financing can no longer be ignored.

New issues for corporate bonds were up by 73% to RMB172 billion in 2007. While that is certainly good news, it still means corporate credit is a marginal asset class and in short supply when the primary market is worth RMB7.98 trillion in total and 90% of issues are accountable by central-bank bills, treasury bonds and policy-bank bonds.

It may be a modest beginning but one that investment managers welcome. Institutions and fund managers are building up a new credit-analysis capability, with more relying on their own research rather than simply follow a credit rating agencyÆs opinion.

Thomas Tang, portfolio manager for fixed income at China Asset Management in Beijing, researches credit issuers like stock, which is still a recent concept in China. The corporate bond market still has a long way to go. He says information disclosure can be a problem and investments into riskier, more obscure names do not pay out. Tang reckons sovereign and quasi-sovereign credits are offering more attractive yields and liquidity.

Transparency and disclosure still need improvement. ChinaÆs young credit-rating agencies are not considered reliable, so bond prices may not reflect market expectations of a companyÆs ability to pay. Many investors still avoid corporate bonds, believing they are not being adequately compensated for the risk of default, because they canÆt calculate it.

There are currently five domestic rating agencies: China Chengxin International Credit Rating (CCXI), China Lianhe, Dagong Global Credit Rating, Shanghai Far East Credit Rating and Shanghai Brilliance. They are all working with the CSRC to devise better models. In the meantime, Standard & PoorÆs and MoodyÆs Investor Service have local JVs with Citic Securities and CCXI, respectively û but itÆs still not clear what they will be allowed to do.

As such challenges get worked out, the longer term one will remain liquidity. This can be partly addressed through structural reforms. According to Pei Chuanzhi, vice president at China Foreign Exchange Trade System & National Interbank Funding Centre, consolidating trading platforms and introducing electronic systems will be essential to long-term success. Foreign advisors such as the Chicago Mercantile Exchange and software vendor Sungard are partnering with the centre to look at ways build a more robust system.

In the meantime, Mark Parsquale, managing director at GFI Group in Beijing, says another key reason why liquidity is still missing is because dealers and brokers are still absent in the inter-bank market, where the government sets rates by fiat and where banks trade amongst themselves, without market makers. But the inter-bank arena is unlikely to benefit from product innovation, or to see spreads narrow, without introducing more market-based practices.

While observers agree ChinaÆs bond market will continue to be reformed and progress, the sheer number of things to tackle can lead to confusion and paralysis. What should be the governmentÆs focus now: introduce interest-rate swaps? Develop the Shanghai Interbank Offer Rate (Shibor) market? Deregulate the inter-bank space?

In the meantime, although investors are keen to see the corporate bond market grow, they doubt it will provide good returns in the short run, as the central bank tightens monetary policy (driving down bond prices) and as companies suffer from falling share prices.

Mutual-fund executives are likely to see their recent marketing push for bond funds (begun this year as the A-share market tanked) end in tears because performance wonÆt be very good in an environment of rising interest rates.

Institutional investors, meanwhile, are dismayed because the credit space, which in theory should be an important tool to solve their liability/asset mismatch, isnÆt performing as it needs to do.

In the insurance sector, CIOs are taking the matter into their own hands û either as Liu at China Life who is looking to create his own innovative products for the market to trade; or as John Pearce at Ping An Insurance, who is pushing to invest more in private equity, real estate or international assets.

ô2008 is not the yearö for domestic bonds, says Yao Gang, MorningstarÆs top-rated fixed-income manger at Fullgoal Fund Management.

But for a growing number of mainland investors, not having a proper domestic fixed-income market in the year when the stock market fell apart is going to make the pain that much worse.