China took a significant step towards opening its doors to foreign capital – a core element of its economic vision – with the launch of Bond Connect in July.
Bond Connect enables institutional foreign investors to buy and sell renminbi-denominated bonds without having to open onshore accounts. It does this by providing a trading channel between Hong Kong and the onshore China Interbank Bond Market (CIBM), as well as the financial centres of Shanghai and Shenzhen.
The link offers enormous opportunity to the savvy investor for several reasons, including the massive size of China’s bond market, the huge potential for market growth (see chart below), the diversity of issuers and the prospect that a more open market will lead to the inclusion of Chinese debt offerings in global bond indices.
Launched to coincide with the 20th anniversary of the UK’s handover of Hong Kong to China, Bond Connect is a major financial development for the country. It follows the introduction of Stock Connect in 2014, which enabled foreign investors to buy Chinese A-shares on the mainland more easily.
Seven billion yuan worth of bonds were traded on day one. Despite the encouraging start, many investors continue to adopt a ‘wait and see’ approach due to concerns about weakening economic growth; the developing nature of the country’s institutional and legal infrastructure; and questions around the efficiency of capital allocation.
Among the most important factors to evaluate when considering an investment in the Chinese bond market are the amount of credit risk, the lack of independent ratings, foreign exchange exposure and the level of compliance with international accounting standards.
Credit risk reflects the probability of default and the consequent recovery value. Admittedly this is a difficult topic in China, especially in the onshore market. There have been too few cases to draw any statistically significant conclusions, although there is some anecdotal evidence. According to BNP Paribas¹, the first onshore default was in 2014, and defaults are kept low by the government at c. 0.5%. The majority of cases resulted in 100% recovery in the BNP study, with the lowest recovery rate being 22%.
As a comparison to the BNP study recording a 0.5% default rate, Moody’s² expects Asia’s (HY) US dollar bond market default rate to remain moderate at 3.1%. Furthermore, the same report shows that there were 21 defaults between 2001 and 2016 by Chinese issuers, with recovery rates ranging from 7% to 90%. Not surprisingly, there is high correlation between credit rating and recovery rates. The amount of credit loss increases exponentially as one goes down the rating scale. This highlights the clear need for thorough research.
At present, most of the onshore issuers and bond issues are not rated by any of the international rating agencies; in August, 66 issuers out of more than 6000 had bonds outstanding on both the onshore and the offshore hard currency market, of which nine were not rated. The ratings environment is likely to change in the near future. Following the launch of Bond Connect, ratings agencies such as Moody’s and S&P have been given the ‘green light’ to rate Chinese domestic issuers and issues.
FX exposure can be a key consideration for potential investors too. However, FX hedging can be achieved in either the onshore or the offshore market, on either the CNY or CNH basis and transactions are conducted via settlement accounts in Hong Kong. Market makers include most existing mainstream hard currency market makers such as HSBC, Standard Chartered, BNP Paribas, Citi and JP Morgan.
China GAAP (China’s accounting standards) is now substantially similar to IFRS (international financial reporting standards) and US GAAP (US accounting standards). There are some minor discrepancies, though. For example, under the IFRS, companies can choose between historical cost or market based revaluation as the valuation method for certain types of fixed assets, whereas China GAAP only allows the former.
China’s onshore bond market demonstrates many emerging market (EM) traits. For example, deal origination is often underwritten to issuer preference, rather than for distribution, resulting in illiquidity. This is improving, helped by proactive panda bond (a renminbi-denominated bond from a foreign issuer, sold in China) issuers such as Daimler Chrysler, who have been seeking to drive change.
Lack of credit differentiation is another distinguishing feature of the Chinese bond market. This feature projects itself in two dimensions.
First, the onshore market is dominated by short-dated bonds - 88% of bonds mature within five years and 63% within three years. The predicament of not being able to price credit risk has manifested in short duration, which in turn presents accumulated refinancing risk. For those who are prepared, this also presents opportunities to create alpha. In the last 7-8 months the Chinese authorities have been focusing on financial stability and financial deleveraging. The resulting tight liquidity led to an exaggeratedly flat credit spread curve at the front end. In August, China Merchant’s (a tier 2 bank - Baa1 rated by Moody’s and BBB+ by S&P) 6 months CNY paper yield of 3.5% in US dollar terms (ie after FX hedging) was superior to its 2018 USD bond, which yielded just over 2%. This window of opportunity has subsequently diminished, in part due to changes in the USD / CNY outlook.
Second, spreads between higher and lower ‘rated’ issues do not justify the difference in quality of issues. As the charts below (below) demonstrate, from July 2014 to date, investment-grade CNY bonds trade ‘richer’ than US dollar bonds in spread terms and vice versa on high-yield bonds. This gap peaked around mid-July this year.
Another feature of the onshore bond market is the issuing structure compared with the offshore hard currency market. For years, the majority of Chinese hard currency credit investors have been structurally subordinated to their onshore peers. This is because the issuing entities of these offshore bonds are often offshore subsidiaries which are, in turn, subordinate in their claims to the bulk of these issuers’ assets that are often located onshore. In theory, investing directly in the onshore market removes this subordination, although in practice there is evidence of positive discrimination. The largest default in recent history, China City Construction Holding Group, defaulted on nine onshore bonds and one CNH (ie offshore renminbi market) bond. The case is ongoing, but so far investors of the defaulted CNH have received more favourable treatment than the onshore creditors, who demand that the company adds cross-default provision.
The question of what represents fair compensation for structural pitfalls in the market is a matter for subjective debate. In the meantime, it is clear that China’s Bond Connect allows for additional relative value and potential diversification opportunities.Yes there is risk, but, as the Chinese proverb says, “Pearls don’t lie on the seashore. If you want one, you must dive for it.”
1 BNP Paribas, September 2017 (data range 2015 to date)
2 Default and Recovery Rates of Asia-Pacific Corporate Issuers, Excluding Japan, 1990-2016H1, Moody’s, October 2017