Though largely ignored or misunderstood by many investors, China’s onshore, local-currency bond market has grown to be the third largest in the world, at over $7 trillion. Some estimates call for it to almost double in the next several years. The growth has occurred despite restrictions on foreign investment in such assets.
Last year, however, new rules allowed practical participation in this large bond market.
A Closer Look at China’s Onshore Bond Market
Broadly speaking, there are two onshore cash-bond markets1 in China, 60% of which are government bonds issued by the central government, local governments throughout the country, and policy-bank bonds.2 The remainder is issued by non-government entities such as commercial banks, industrial corporations and other non-bank financial institutions (Exhibit 1).
These bonds are owned primarily by Chinese domestic banks, with foreigners currently owning less than 2%. However, foreign participation is likely to increase over time—particularly if and when global bond-market indices begin to include China. Additionally, we think investors may find opportunities to benefit from mispricing of Chinese bonds stemming from market-structure issues, one of the most obvious of which is the lack of credit differentiation between issuers.
The Case for Owning Chinese Local Currency Bonds
In our view, the most obvious benefit of owning Chinese bonds is that their current yield can be significantly higher than bonds of similar maturity in developed markets. What’s more, the correlation between the interest-rate movements of China’s government bonds and those of other governments tends to be low and could make the former a potentially attractive alpha-generating investment.
Also, China’s onshore bond market is relatively deep and liquid compared with its offshore counterpart. For example, it is ten times larger and could potentially benefit investors with a larger selection of securities across the liquidity spectrum.
Finally, a comparison between the short-term interest-rate volatility of onshore and offshore bonds reveals a critical point: Onshore bonds tend to be less affected by foreign-exchange expectations and can therefore be evaluated on a more fundamental basis rather than on the whims of the foreign-exchange market (Exhibit 2).
Looking for Better Entry Points into China’s Onshore Bond Market
Yet there are still notable risks for investing in China’s onshore bonds. A change in local capital-control rules could cause some investor assets to be stranded in China; the lack of credit tiering among many issuers is suspect, particularly since many issuers’ ratings are determined by local agencies, whose rating standards are still highly questionable; the balance sheets of many corporate issuers are highly leveraged; and the future value of the Chinese currency is in doubt—and poses a risk to the value of onshore bond investments in local currency.
For these reasons, our Global Debt Team is taking a cautious stance on the asset class. However, in our view, these risks do not negate the growing case we’ve mentioned for owning these bonds. And on a fundamental level, China’s stabilizing growth—as well as its government’s priority to maintain that stability throughout 2017—should be a positive factor for local assets.
We’re keeping a watchful eye as the opportunity develops and the risks subside.
1 Cash bonds typically offer periodical fixed-coupon rates of interest that are paid in cash.↩
2 Policy-bank bonds are bonds issued by China’s three policy banks, which include the China Development Bank (CDB), the Export-Import Bank of China (EXIMCH) and the Agricultural Development Bank of China (ADBC).↩
Fixed income investing entails credit, liquidity, and interest rate risks. Bonds are exposed to credit and interest rate risks. When interest rates rise, bond prices generally fall. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Diversification does not guarantee profit or protect against loss.
This material is for informational purposes only and is not intended to be investment advice, a recommendation, or to predict or depict the performance of any investment.
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