The evolving Chinese onshore bond market: Be wary of additional risks

The recent inclusion of the Chinese onshore bond market within broader global bond indices has increased the level of investor attention to the market. Despite its size, the Chinese onshore bond market behaves somewhat differently to those of developed markets. This has implications for investors wanting to access parts of the onshore markets beyond those included within the broader global benchmarks.

What is in the Benchmark?

For investors wanting an exposure to the China bond market it is important to recognise that not all of the onshore bond market in China has been included within the global indices. Taking one of the more commonly used global bond indices - the Bloomberg Barclays Global Index - as an example, the included exposures comprise Central Government Bonds and Policy Bank Bonds. These more liquid bonds constitute those parts of the bond market which are explicitly, or effectively, guaranteed by the central government.

Split evenly, these two bond classes together comprise nearly 40% of outstanding issuance (Figure 1). This means that nearly 60% of the onshore bond market has not been included within the broader global indices. For investors wanting to access these two ex-benchmark exposures (Local Government Bonds and Corporate Credit) there are considerations they need to be aware of.

Local Government Bonds – A bank market

The first consideration is associated with the market for local government bonds, which comprises a material proportion of the onshore China bond market - around one quarter of the onshore China bond market.

Despite its size the recent development of local government bond market has created issues for investors. Importantly it is not the rapid growth in the market which has created issues for investors but rather the way that this rapid growth has come about.

Developing from 2014 onwards, the local government bond market owes its rapid growth to central government policies designed to encourage local governments to borrow directly via the bond market. Prior to this change in policy the major Chinese banks were the key providers of funding to local governments. At first glance the growth in the local government bond market would indicate that the central government policies towards financial disintermediation are a success. The reality is however that the mechanism via which banks provide funding has changed rather than local governments becoming less reliant on banks themselves for funding. This is due to the major banks providing finance to the local governments by being the major buyers of local government bonds. The banks then hold the bonds on their balance sheets to maturity. The result is that a material part of this market, around 80%+ of issuance, is locked away within bank balance sheets and isn’t traded. For investors wanting to access this part of the market the result is that liquidity is relatively poor and trading costs quite high. This makes non-bank participation within this part of the onshore bond market quite limited and largely restricted to ‘on the run’ issues.

Local Credit Ratings – Not much risk differentiation

The second consideration worth highlighting is associated with the corporate bond market which again comprises around one quarter of the total onshore Chinese bonds outstanding. The key factor driving the nuances within this market are associated with only local ratings agencies being allowed to rate corporate issuers. Despite the broad range of corporate issuers, ranging from large quasi government entities to small privately owned companies, the ratings scale utilised by the local rating agencies effectively ranges from AAA or AA. Complicating the interpretation of the ratings even more is that local ratings are not recognised outside of China and don’t directly correspond to the more broadly utilised global ratings criteria. As a ‘rule of thumb’, it is generally accepted that a AAA to AA+ rating denotes that an issuer is ‘Investment Grade’ whereas below AA+ denotes that an issuer is ‘Non-Investment Grade’.

Although there is a degree of spread differentiation between investment and non-investment grade issuance, there tends to be a lack of yield differentiation within ratings bands. The impacts arising from this lack of risk differentiation between issuers is most evident when one considers that 80%-90% of issuers (excluding Policy Banks and Local Governments) are rated AAA to AA+. This lack of ratings differentiation results in a material portion of the local investor base, mainly retail investors, typically paying little attention to official ratings when pricing bonds. In the absence of ratings differentiation, when determining the pricing of corporate bonds, the name of the issuer is of far greater importance.

But doesn’t a market which can be viewed as being somewhat inefficient create opportunities for savvy investors? ‘Yes’ and ‘No’.

• Yes - in that an investor which is prepared to put in the time and effort can identify corporate credits where the pricing is out of kilter with perceived fundamentals.
• No - in that having identified such opportunities there is no guarantee that the subsequent movement in pricing will reflect fundamentals.

With a material part of the market comprising local retail investors, the changing sentiment to issuers and resulting flows is the key determinant of relative pricing, rather than the underlying fundamentals of the issuer. The upshot of this still evolving approach to differentiating between credit risks is that within the onshore Chinese corporate bond market the pricing of risk is not necessarily efficient. This is not to say that fundamental credit analysis cannot give an investor the edge in being able to avoid defaults. Rather, at the end of the day, an investor taking on more credit risk cannot take it for granted that they are necessarily being appropriately compensated for assuming a higher level of risk. On a positive note there are signs that greater risk differentiation is being built into corporate credit markets. With that said there is still a long way to go before risk differentiation approaches the levels seen in more developed bond markets.

The onshore Chinese market is a large market which in many ways is still evolving. Although materially larger than many developed bond markets, it still has some of the attributes of a developing market. These characteristics can make it difficult for investors to efficiently access material parts of the onshore bond market. For investors wanting exposure to onshore China bonds, it’s best to remain focussed on the more liquid/higher quality end of the market. This means that a material part of any onshore China bond fund will comprise of Central Government and Policy Bank bonds. It’s equally important to recognise that, when considering the expansion of mandates to include corporate credits, the higher quality issuers are more likely to provide an attracting risk/return profile. If an investor is looking to move materially down the corporate credit spectrum, then it’s essential to ensure that the capabilities are in place to undertake the detailed fundamental analysis necessary to avoid defaults as the pricing dynamics may not compensate for the higher level of risk assumed.