Chinese dollar-denominated bonds are, in our view, an attractive investment right now for a number of reasons. The arbitrage opportunity arising from the wide yield gap between China’s onshore and offshore debt (where bonds are sold by Chinese companies outside of the mainland market) is making these dollar-denominated credits look appealing versus their domestic counterparts. The yield differential between the two in high yield bonds was close to a three-year high of around 4%, despite a recent rally in China’s offshore high yield bonds. Moreover, yields on local bonds are being pushed down further given Chinese authorities have been introducing liquidity into the domestic financial system in a bid to cushion its cooling economy.
China’s dollar high yield bonds provide higher yields than local bonds
A key implication of the yield differential is that companies have access to borrowing at a cheaper rate since the second half of 2018, which means there was very high perceived risk by international investors. This yield differential is a great comfort for us, as we believe issuers having access to cheaper funding channels onshore should alleviate fears surrounding refinancing risk and defaults.
This also means that as investors, we can enjoy potentially higher yields from the dollar bonds market. Given the recent Chinese yuan (CNY) stability, onshore bids as expected were seen taking advantage of this arbitrage opportunity.
There are a number of other positive drivers for the Chinese offshore bond market. Bond Connect, which allows foreign investors to buy bonds trading on China’s interbank bond market directly through the Hong Kong exchange, celebrated its first anniversary last year and is gaining momentum. Although Bond Connect only facilitates the buying of onshore debt, it is significant for buyers of offshore bonds in that companies can refinance cheaper onshore, thus reducing refinancing risk and lower financing costs, which are a credit positive. In August it launched the delivery versus payment (DVP) feature, removing a major hurdle which limited the scheme from attracting more overseas investors. Payment for bonds is now due at the time of delivery, substantially reducing settlement risks. This followed on from the launch of block-trade allocations, which allow asset managers to allocate block trades to multiple client accounts. Investors can also trade this market directly via Bloomberg terminals, with real time pricing providing further ease of access.
Allied to this, Standard & Poor’s has been given the green light by the People’s Bank of China to start rating issuers in the onshore bond market, making it the first foreign credit ratings agency to do so; this all adds further transparency and accessibility, as well as making the market ever more sophisticated.
A further plus is the fact Chinese bonds are set to be included in the Bloomberg Barclays Global Aggregate Bond index for the first time from April this year; China will account for around 6% of the index upon completion. This will open up the market yet further and bring in inflow from local currency index investors – all of which helps to raise the profile of the Chinese fixed income market.
China can afford to delay dealing with its debt burden for now, in our view, but in the medium to long term it will need companies to deleverage (pay off debt on their balance sheets) and requires a more effective monetary mechanism and more efficient resource reallocation processes. We remain confident, though, that the authorities will be able to control the pace of the slowdown.
We feel we are approaching an exciting tipping point in the development of the Chinese bond market. Increased levels of foreign investment should bring increased credibility, liquidity and sophistication to what has the potential to be a huge market. We continue to monitor developments closely with an aim to capitalise on the opportunities it throws up.