Precursor to further advances
The opening-up of the Chinese onshore bond market – already the third largest in the world – and the fuller inclusion of Chinese bonds in global indices marks the beginning of what should inevitably be a prolonged catch-up process. Standing at around USD 12 trillion, the Chinese market only lags those of the US and Japan. It is likely to overtake Japan relatively soon given its rapid growth.
While large, this market accounts for only around 85% of local GDP, while the volume of most developed bond markets exceeds 200% of GDP. Surprisingly then perhaps, China is still one of the most under-owned markets by foreign bond investors, reflecting a history of strict capital controls, regulatory uncertainties and relative illiquidity.
Exhibit 1: Foreign ownership of outstanding local bonds (in %)
Source: JPMorgan, official sources, end February 2019
Not only is it huge, but the onshore Chinese fixed income market is also relatively diverse, offering investors access to a wide array of instruments with a range of credit profiles. Local ownership is shifting: pension funds, insurers and asset managers have recently been buying bonds, widening ownership beyond the current dominance of commercial banks.
Overall, we think that the long-term story is positive. Although we expect rising supply at the sub-sovereign (especially provincial) level, contained inflation, moderate fiscal and monetary stimulus and foreign demand should help keep yields low. In the shorter term, however, we expect volatility as many local investors are likely to shift from money market or conservative fixed income funds to more aggressive equity funds. Accordingly, domestic demand could weaken.
Index inclusion: a game changer
The final weight of Chinese bonds in the Bloomberg Global Aggregate index1 will be in excess of 6% by November 2020. Current rules for inclusion are strict: bonds have to pay a fixed coupon, have an outstanding amount of at least RMB 5 billion and a remaining tenor of one year or more. We estimate that passive inflows linked to inclusion could amount to USD 120 billion over the next couple of quarters.
In addition, the likely inclusion in the JP Morgan GBI EM Global Diversified index could trigger roughly USD 20 billion in inflows and the potential inclusion in the FTSE WGBI another 150 billion. Overall passive inflows could total USD 250-300 billion.
Should foreign ownership rise to the levels seen in mature markets or smaller emerging markets, this would translate into several USD trillions of inflows in the years to come.
We expect central banks to feature among the buyers as they allocate reserves to the onshore market. Allocations now stand at roughly 2% of assets, more or less matching holdings in Australian and Canadian dollars. Overtime, we expect the weight of RMB-denominated assets to exceed 5%.
Fundamentally mispriced = opportunities
We believe the Chinese bond market has a unique risk/reward profile compared to other emerging markets.
While onshore investors view Chinese bonds as risk-off, from a foreigner’s perspective, they are seen as risk-on with low correlation with local currency emerging market debt instruments. With onshore credit typically priced top-down (i.e. reflecting the level of government support) rather than priced for credit risk, spreads have been tight. While many domestic rating agencies have assigned bonds AAA status, credit risk has actually been significant.
Exhibit 2: Correlation of Chinese government bonds with eerging and developed markets
CGB: China government bond; GBI EM: JPMorgan Global Bond Index Emerging Markets; DBR: German government bonds; UST: US Treasury; JGB: Japan government bond; source: BNPP AM, Bloomberg; monthly returns over two years to April 2019
However, policymakers are now willing to inject more credit risk into the system, causing spreads to widen as ratings are reassessed and brought more into line with those of global issuers. The gradual opening-up of the market to foreign rating agencies would be encouraging.
We expect higher corporate spreads in the short term and a rise in onshore defaults. This might be painful in the short term, but should be seen as a healthy longer term development.
Overall, it is our view that the mispricing created by the divergence in assessment by domestic and foreign investors allows for alpha generation. Opportunities await.
A look at the segments
Debt denominated in US dollars has surged in the past decade. The uncertainties surrounding the outlook for the balance of payments and the renminbi in 2018 raised concerns over refinancing risks, but for professional investors who closely follow the developments and remain aware of the issues, the asset class can provide ample opportunity for generating alpha.
When it comes to bond issues by the much discussed local government financing vehicles (LGFVs), actively monitoring the direction of policy and issuer research could help investors find mispriced opportunities.
The Chinese government has taken steps to address investor concerns. It has extended its debt swap programme, where the government issues bonds to replace debt of LGFVs and other quasi-fiscal entities to ease their interest burden. LGFV bonds can now be sold on the domestic stock exchange if the proceeds are used for refinancing. Such measures aim to keep systemic risk concerns from arising. While the government’s focus has shifted from deleveraging to stimulating the economy, we do not expect LGFV leverage to spiral out of control.
We favour a bottom-up approach to LGFV investing as government support differs from one LGFV to the next and is more likely for those with policy mandates and greater strategic importance. We would prefer LGFVs domiciled in cities and provinces with a greater administrative significance.
Issues by central state-owned enterprises are a different story. SOE issuers have a broad and stable investor base in the offshore market and their onshore funding access remains strong. In 2018, central SOEs were relatively resilient to rising US Treasury yields and tightening funding conditions.
Fundamentals have improved on the back of efforts to reduce leverage and impose borrowing restrictions. Controlled capital expenditure and fewer overseas mergers and acquisitions should result in less issuance.
Bonds by top-tier central SOEs in strategically important sectors, such as utilities and oil, look less appealing now as they trade at only 10-20bp over South Korean quasi sovereigns with a higher rating. There could be value in less researched, mid-tier SOEs offering a meaningful spread pickup over top-tier SOEs.
The high-yield market is booming, but looks fundamentally mispriced. Default risk has been overestimated. We believe opportunities abound for investors prepared to do the homework and learn how to avoid blow-ups.
 This is an abbreviated version of the April 2019 white paper China’s Great Opening: this time it’s real! by the BNPP AM Emerging Markets Fixed Income team
 JPMorgan GBI-EM = JPMorgan Government Bond Index-Emerging Markets; Bloomberg Barclays Global Agg = Bloomberg Barclays Global Aggregate Bond index; FTSE WGBI = FTSE World Government Bond index; source: BNPP AM, JPMorgan, Bloomberg, FTSE Russell; February 2019
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.