The Credit Voice

The Credit Voice “A jar’s value comes from what it can contain” Invest SA Fabrizio Biondo, CFA Global High Yield Portfolio Manager Credit Strategist < The Credit Voice – November 2020 The recent decision by the FTSE Russell Govern- markets in terms ment Bond Index (WGBI) to add Chinese gov- of size, the rela- ernment bonds to its flagship starting in October tive growth rate is 2021 demonstrates the success of the China’s already very dif- efforts in recent years to open up and liberalize ferent today. the on-shore domestic bond market. The China issues an WGBI’s decision reverses a annual volume rebuff just one year earlier, equal to about and comes in the wake of 80% of that of the other similar recent ap- U.S., and the provals: the Bloomberg trading volumes Barclays Aggregate, on Chinese gov- launched in April 2019, with a implementation ernment bonds over 20 months (to be completed in December (CGB) have liter- 2021); and JP Morgan GBI EM Global Diversified ally exploded in Index, which began including Chinese govern- recent years. The ment bonds in February this year. These three in- market shows dices collectively drive global investments of clear growth po- about $4-7 trillion, and being included in their tential in the im- baskets could generate a flow of foreign capi- mediate future, tal to China's domestic market of about $250- for two reasons: the size of the market in relation 400 billion. In all likelihood, it could be just a taste to GDP, which in China is much smaller than in of what’s to come. the main advanced econ- With an estimated capitalization of $13 trillion, omies (<100% the Chinese bond market is already the world’s compared to second-largest, about one-third of the size of 150%-200%), the American and the par- market, and ticipation rate ahead of Japan. of foreign in- Despite the vestors, which great distance is still limited, at that continues to about 2.5% separate the U.S. compared to the 15-60% level in the other major and Chinese world economies. - 1 - Looking at the first reason, the weight of Chi- than a quarter of the total capitalization, is still nese domestic bond instruments in the global marginal. bond universe (18%) is roughly in line with the A famous Chinese proverb says, however, that weight of the Chinese economy in world GDP a jar’s value comes from what it can contain ra- (16%), a sign of the domestic market’s underde- ther than what it contains today. Major players velopment, if on the international financial scene (institutional we consider investors, insurance companies, pension funds, that the U.S. brokers, investment banks, rating agencies) are bond market all beginning to understand that if the Chinese accounts for domestic bond market were a jar, that jar over 50% of would contain the next decade’s best invest- the world’s to- ment and business opportunities, in bonds and tal, while its beyond. weight in the As far as institutional investors globally are con- world economy is about 24%. Therefore, the cerned, the shortage of attractive opportunities Chinese economy is about two-thirds the size of in traditional markets, combined with a marked America’s, but its domestic bond market is less quantitative and qualitative improvement in than 30% of the American one. Foreign invest- the level of access to the Chinese domestic ment has grown quite rapidly in relative terms market; Chinese since 2017, thanks to a series of initiatives aimed government and at liberalizing the quasi-government market and mak- bonds being in- ing it more easily cluded in major accessible from global bond indi- abroad. But in ab- ces; growing liquid- solute terms for- ity; low historical eign investment re- volatility; and the mains extraordinar- low correlation ily low, and in the with other markets coming years is des- can only mean tined to grow con- one thing: inevita- siderably, together bly, a higher level with the market as a of investment. The whole. goal is to capitalize This foreign investment for the time being is almost exclusively limited (98%, according to UBS) to government bonds (China Government Bonds or CGB) and securities issued by China's three major public banks (China Development Bank, Agricultural Bank of China, Export and Import Bank of China), better known as Policy Financial Bonds on attractive yield (PFBs), which collec- differentials and low tively account for just levels of volatility over 30% of China's to- and correlation, tal bond market capi- and achieving talization. The pres- greater efficiency in ence of foreign inves- asset allocation. The tors in the corporate Sharpe Ratio, which is set against the last five bond segment, which years of historical volatility, unequivocally shows today represents more - 2 - the benefits that in- package. Although the total percentage of the vesting in domestic market held by foreign investors is still very low - Chinese securities - at 2.5% as mentioned -- the percentage of could have government bonds (CGB) they hold has risen to brought to a global almost 9%, demonstrating that the globalization bond portfolio. trend in this specific market China has made progress in providing foreign segment has investors with greater flexibility in accessing the already begun. Chinese domestic bond market, with the transi- On the other tion beginning in 2016-17 away from infrastruc- hand, investor ture lacking basic risk management tools, sub- interest in ject to high uncertainty about capital repatria- China’s corporate bonds remains marginal for tion, and based on quotes, such as QFII/RQFII reasons we need to examine closely. These rea- (quotes later removed in 2019), and towards sons are destined to gradually disappear in the flexible platforms without quotes (CIBM direct, coming years, thereby giving a strong impetus Bond Connect), equipped with interest rate de- to this asset class rivatives and repo instruments (CIBM Direct) or as well. In the aimed at mitigating the risk of capital repatria- meantime, this tion (Bond Connect). These new platforms are domestic market leading to a sharp increase in foreign investor has been quite inflows. Bond Connect, in particular, launched active, with a in 2017 jointly by the Chinese Central Bank significant in- (PBOC) and the Hong Kong Central Bank crease in corpo- (HKMA), has become the preferred access rate issues com- mechanism for foreign investors through its pared to previ- Northbound Connect channel, which provides ous years: an im- access to the onshore bond market via Hong portant change Kong without the need to open a domestic ac- given that Chi- count. It’s enough to register with the PBOC nese companies through the China Foreign Exchange Trade Sys- have tradition- tem (CFETS) or the 34 designated dealers. ally preferred There are now bank credit to more than 2200 cover their fi- registered for- nancing needs eign investors, (which repre- and investments sents more than held by foreign- two thirds of the ers total 3 trillion corporate fund- renmimbi (ap- ing mix). Banks, proximately $450 billion). The growth rate looks for their part, are set to accelerate significantly over the next two the main holders years, as initiatives multiply to further simplify ac- of Chinese do- cess proce- mestic bonds. They directly, and indirectly dures and to through WMP (wealth management products), include or im- hold a share close to 70%. Chinese companies prove the nec- tend to rely on bank credit to a much greater essary risk man- extent than companies in the main advanced agement tools economies, and when they make use of corpo- in the overall rate debt issues, it is mainly the banks them- selves that are the main investors. The process - 3 - of banking disintermediation has slowed down difficulty of analyzing the credit quality of do- dramatically since 2015, and there is still a long- mestic Chinese bonds, due local rating agen- ways to go in the future compared to the G20 cies applying different standards than those of average and to the U.S. situation. In the mean- the large international agencies; 2) the domi- time, the undeniable appetite of international nant presence of SOE (state-owned enterprises) investors (espe- at issuer level, whose credit quality is intrinsically cially Asian in- very low and whose yields do not accurately re- vestors) for Chi- flect risk because of the implicit guarantees; 3) nese corporate valuations, which bonds is satisfied do not appear almost exclusively particularly gen- in the dollar-de- erous when com- nominated bond pared to those of market, which now accounts for more than half Chinese bonds in of the Asian dollar credit market. dollars. Let’s take a closer look at what is putting a Regarding credit quality, over 70% of Chinese brake on international investor demand for cor- domestic bonds have an AAA rating, and al- porate bond issues in the Chinese domestic most 30% an AA rating, with the remainder rep- market, bearing in mind that recent regulatory resented by A bonds (<1%). However, these rat- developments -- such as the simplification of the ings are as- procedures for private placement of shares signed by local (February 2020) and those for the registration of rating agencies corporate issues (March 2020) -- clearly demon- (China Bond strate the authorities' commitment to improving Rating, Golden the country’s direct financing channels, as reit- Credit Rating In- erated by the head of the CBIRC (the regula- ternational, tory authority in the CCXI, Shanghai banking and insur- Brilliance, CSCI, Dagong) and do not reflect in- ance field) in a re- ternational standards. A-rated issuers appar- cent interview (Au- ently represent the floor of credit quality in gust 2020).

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