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China's Bond Market--The Last Great Frontier

Editor's Note: This article, by S&P Global Ratings and S&P Global (China) Ratings, is a thought leadership report that neither addresses views about ratings on individual entities nor is a rating action. S&P Global Ratings and S&P Global (China) Ratings are separate and independent divisions of S&P Global.

Chart 1

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Total bonds outstanding of US$17.4 trillion. Real yields in excess of 100 basis points over equivalent debt in U.S. dollars. Low correlation with global assets. Such numbers speak to the potential of the domestic Chinese bond market, which is only about 3% foreign owned. S&P Global Ratings expects China's ambitious measures to open one of the world's largest bond markets to prompt a global migration.

China is liberalizing its bond market as part of a wider reform effort to establish the renminbi as an international currency, diversify sources of domestic funding, and improve its allocation of capital.

While China's financial model will likely remain a hybrid, with a managed capital account and banks at the center of the financial system, we expect evolution.

The exchange rate will become more flexible over time. Banks' share of credit to the nonfinancial private sector (82% versus 33% in the U.S.) should fall as more institutional investors participate in bond markets.

A rising share of foreign institutional investors may also foster more transparency and risk-based pricing in China's bond market. This may result in a more efficient financial system that diverts capital to its most productive use.

A Growing Mass Of China Bonds Will Exert Gravitational Pull

As China opens its doors, widely used bond indices such as Bloomberg Barclays Global Aggregate Index are tracking the country's rapidly growing bond market. This is pulling billions of dollars of indexed funds into the asset class. Regulators are also making it much easier for offshore money to enter.

To see how large foreign holdings could become over the next decade, consider a purely illustrative scenario with plausible assumptions. First assume that China's bond market capitalization is within a range of between 130% and 160% of GDP by 2030. This compares with 110% at the end of 2020, and about 70% five years ago. In the U.S, the equivalent is 221%.

Now, assume a foreign ownership share of about 10% by the end of this decade. That would put foreign investor holdings of Chinese bonds at between US$4 trillion and US$5 trillion by 2030.

International investors will need to navigate an opaque market as they enter. Global fund managers largely do not cover the 6,000-plus Chinese debt issuers. Meanwhile, domestic credit ratings provide limited differentiation of credit risks, as over 80% of the local ratings on nonfinancial corporate issuers are 'AA' or above.

Institutions must untangle qualitative concepts such as the degree of state support backing state-owned enterprises (SOEs). Defaults are rising among these entities. This is off a very low base, but it does confirm that the state is serious about its well-stated intention to end the implicit guarantee. The unwinding may be disruptive and create pricing volatility along the way.

For all the complexity, we anticipate international investors will increasingly need to consider Chinese domestic debt. The potential role of the renminbi as an international currency used in trade and invoicing is likely to encourage foreign ownership of renminbi assets.

The country's bond market is under-scrutinized and is not very correlated to other asset classes. Some global fund managers have entered the market for these reasons, and more are likely to follow. They just need to do the hard work of surveying this market.

Recent Portfolio Characteristics Of China's (Government) Bonds

Shaun Roache 

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Bond investors care about two things above all: return and risk. Achieving the highest return possible with risks commensurate with either their mandate or their own preferences are the priorities.

This is where China's bond market comes into the picture. Consider first Chinese government bonds. While only one part of the bond market, these securities set the benchmark yield off which most other bonds in the market are priced.

In early April 2021, Chinese 10-year government bonds paid a yield of 3.2%, about 160 basis points yield higher than the U.S. 10-year Treasury note. Chinese government debt is denominated in renminbi, while most global funds will care about their returns in U.S. dollars and may use cross-currency swaps to reduce their exposure to currency fluctuations.

Currency swap rates can change but, again in early April 2021, an investor who wanted to swap the renminbi they received from owning a Chinese 10-year bond to U.S. dollars would pay about 80 basis points, about half of the current difference in yield.

This is not necessarily representative of the actual returns an investor would obtain, but even after hedging out the currency risk, a difference in yield remains.

The deal on real yield.  Currency swap markets can be illiquid, especially at longer maturities stretching beyond five years. An alternative way to compare prospective common currency returns is with real yields on government bonds, which subtract inflation from the yield to maturity. The idea is to account for differences in inflation rates that should be reflected in longer-term changes in the exchange rate.

All else equal, we believe an economy with higher inflation compared with a trading partner would see its currency depreciate, eroding the common currency return. Often, high nominal yields in a country's bond market simply reflects expectations of higher inflation and, for foreign investors, currency losses. Of course, all else is not equal, but this is still a helpful exercise and is a comparison often undertaken by global investors.

China's real yield has been well above that found in the major developed markets for at least a decade. That yield differential has continued to rise post-COVID (see chart 2).

Chart 2

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China's real yields are set to remain above those found in the major global markets for some time. Real interest rates and yields should be related to the real return on capital and an economy's per capita growth rate. While China's growth will likely slow over the coming decade, it will almost surely remain above levels found in Europe and the U.S. In turn, China's real yields should remain above those in the large developed markets.

Investors aim to avoid exchange rate losses when they buy for yield. We have discussed the role of inflation differentials. Currencies are hard to predict. But investors appear to be gaining confidence in China's exchange rate management.

The renminbi is increasingly flexible and driven by market forces. The central bank intervenes much less. While this brings more day-to-day volatility, especially versus the U.S. dollar, it reduces fears of large, one-off changes that are hard for investors to hedge.

Low return correlations help diversify portfolios.  Investors also focus on risk, which we define here as the volatility in the returns of a broad portfolio of assets. The returns from Chinese bonds have been largely uncorrelated with those of other major asset classes that form the bulk of institutional portfolios. Standard portfolio theory suggests that adding assets with low correlations to a broader portfolio can help reduce the variability of returns.

An analysis of the correlation of month-to-month total returns, all measured in U.S. dollars, across major asset classes shows the uncorrelated tendencies of Chinese assets.

The analysis looks at three different groups. First, highly correlated risky assets, including global equities (whether developed or emerging market) and commodities. Second, lower risk assets including global developed market government bonds. Third, Chinese government, nonfinancial corporate, and financial bonds, which are correlated with each other but not anything else (see chart 3).

Chart 3

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Investors might expect these correlations between Chinese bonds and other global asset classes to remain low for a few reasons. First, China's business cycles are likely to show some independence from the business cycle in other major economies.

This means that China's short-term policy rates, the anchor for bond yields, will tend to be relatively independent of those in Europe or the U.S. Second, China will continue to manage its capital account, which will impede very large flows that can swiftly arbitrage between yield differentials.

So, in its broadest strokes, China's domestic bond market has, in recent years, provided a mix of return and risk that appears to have attracted global investors. Historically offshore funds paid little attention to the Chinese market because the government heavily restricted their access. This is changing.

China Is Rapidly Opening Up To Foreign Funds

Charles Chang 

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China's bond market is liberalizing rapidly. The administration of President Xi Jinping is keenly aware that, as the Chinese economy matures, it needs fully functioning financial markets that can efficiently allocate capital.

Beijing has initiated more liberalization of China's financial system in the past four years than in the past four decades. This is particularly apparent in the bond market.

In a matter of four years, the Xi government has dismantled ownership limits, quota systems, and other impediments that had held back the development of China's bond market.

In the earlier stages of its reforms, China was focused on the risks from market forces and foreign investors. The history of emerging markets is littered with financial crises in which foreign capital outflows (often following booming inflows) played an important role.

Now, with fuller confidence built on its reform efforts, China is focused on the efficiency gains that market forces and international investors could bring (see chart 4 for the main recent reforms, and the Appendix table for the full list).

Chart 4

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Just as significantly, the government is backing away from the once widely held belief that it would bail out any distressed SOE.

In 2014, China's domestic bond market got its first default. A year later, it got its first SOE default. This was a stark message to market participants unfamiliar with credit risk and reliant on the government backstop.

As early as 2014, the government warned investors in a directive known as "Circular 43" that they should not take such backstops for granted. Local government funding vehicles (LGFVs) were obligated from that point forward to repay their own debt. The Ministry of Finance in 2016 reiterated the message, which was reinforced in yet more circulars in 2017.

However, it took until 2018 for the message to finally sink in. A jump in defaults since then have underlined that this new discipline is not just guidance, but reality (see chart 5).

Chart 5

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Chinese authorities are also inviting foreign players to participate in its new, market-driven bond exchanges. This opening could eventually allow China's domestic bond market to become a key part of global capital.

The Shape Of China's Bond Market

Xu Han, Fangchun Rong, and Chang Li 

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As more foreign funds flow into China debt, investors must come to terms with the structure of this market. Most broadly put, this realm is huge, opaque, and fragmented. State-backed issuers dominate.

Entering one of the world's largest bond markets.  This is a US$9.4 trillion market. That takes into account all domestic corporate bonds (financial and nonfinancial) of a tenor of one year or more that were outstanding as of February 2021. This surpasses the US$7.7 trillion in equivalent debt outstanding in Europe, of a tenor of one year or more. China's domestic corporate (financial and nonfinancial) bond market is just a hair behind that of the U.S., which has US$9.7 trillion in equivalent bonds outstanding, of a tenor of one year or more.

This is a notable number, particularly when considering the volume of domestic bond outstanding in China has grown at an average annual rate of 49.6% since 2001 (see chart 6). This once again encompasses corporate (financial and nonfinancial) issuance of one year or longer.

Chart 6

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When sub-one-year funding is added, China's domestic corporate (financial and nonfinancial) bonds outstanding rise to US$10.5 trillion. Adding national and local government debt brings the figure to US$17.4 trillion. The simple point is this: this is a big market, and one that has been largely ignored by offshore funds till now.

Chart 7

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A large market split into many spheres.  Bond trading in China is split between the interbank and exchange markets (including both the Shanghai and Shenzhen stock exchanges). Most Chinese bonds are held in the interbank market.

As implied by its name, the interbank system largely involves banks trading debt with each other. Qualified nonbank and nonfinancial institutional investors can also trade here. The counterparties tend to be big and creditworthy institutions, dominated by banks.

The exchange market is smaller. It comprises a much wider range of parties, including individuals.

China's local governments are big issuers of government debt, and they vary widely in creditworthiness. The corporate market is split between the private sector and SOEs. SOE debt is priced with at least some assumption that the state will back a given firm in times of distress.

Onshore investors have started to put more focus on assessing an SOE's stand-alone credit profile rather than just assuming government support. This follows a string of SOE defaults in recent years.

A gradual move to fundamentals-driven pricing should help foreign investors adapt to this market. They are generally more comfortable assessing fundamentals, and find it difficult to evaluate implied government support.

A large number of domestic issuers, with SOEs playing a critical role.  There are more than 6,000 issuers with domestic bonds outstanding. Foreign players coming into this market for the first time face challenging evaluation tasks. They must become familiar with the vast issuer base, and come to terms with China's particular credit and counterparty risks.

Chart 8

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Financial issuers account for more than one-third of domestic bonds outstanding, and nonfinancial SOEs account for 21%.

Chart 9

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What is the maturity profile?  There are significant volumes of Chinese bonds coming due in the next five years. Chinese entities tend to issue debt of shorter tenors than their counterparts in the U.S., Europe, or other markets (see chart 10).

Chart 10

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Banks and other financial institutions dominate bonds and tend to drive much of this shorter-dated issuance, accounting for much of the bonds that are coming due this year (see chart 11).

Chart 11

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Banks typically issue shorter-term debt in tenor and lend at a longer tenor. They earn a spread on the maturity mismatch. As financial institutions are such big issuers, and nonfinancial corporates also tend to issue bonds of one to two years in tenor, China's corporate bond market is of a shorter tenor than other major markets.

Chinese issuers generally prefer to issue at shorter tenors to capture relatively lower funding costs. This is particularly true of SOEs. On the demand side, the market's long-term bond investors are constantly on a lookout for longer-duration assets (tenors of five years or more) to better match their liabilities. This include pension firms and life insurance companies.

As the Chinese market matures over the next decade, we expect to see more longer-dated corporate debt, creating more meaningful yield curves. This will facilitate price discovery and trading.

Foreign participation is climbing...off a low base.  Foreign participation is growing, largely thanks to measures to open this market and the inclusion of Chinese bonds in global bond indices.

Foreign participation in China's renminbi-denominated government bonds was 4.3% as of September 2020. This contrasts sharply with the level of foreign participation in other emerging markets (see chart 12).

Chart 12

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Foreign investors hold just about 3% of China's domestic bonds outstanding. However, we believe offshore funds will become much more active in this market.

On April 1, 2019, the Bloomberg Barclays Global Aggregate Index became the first major global fixed-income benchmark to include a slice of China's vast onshore market. About US$2.5 trillion of assets track this index. With China's weight in the index reaching 6%, this would imply inflows of US$150 billion.

Other index providers will likely follow. FTSE Russell's World Government Bond Index, tracked by about US$2 trillion-US$4 trillion of assets, will also see China's proportion rise to a targeted 5.25% through a three-year phase-in period.

This inclusion in global indices pushes international investors into this market, and institutionalizes China's place in global portfolios.

Lots of regulators equals lots of fragmentation.  Six different regulators control different parts of this market. This has a fragmenting effect. For example, enterprise bonds that are regulated by the National Development and Reform Commission tend to have a stronger credit profile than other corporate issuers. Foreign funds coming into this market need to get a grasp on such subtleties (see chart 13).

Chart 13

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Which regulator oversees which instrument has implications for pricing, trading, funding, and even the post-default trading mechanism.

This multitude of regulators complicates the investment process, from underwriting to rating to investing. It also raises regulatory risks, as guidelines and penalties could come from any of the six bodies.

The government is creating a more unified regulatory system in China. This will make it easier for foreign parties to navigate this market.

Inflated ratings don't help credit differentiation.  Local ratings on nonfinancial corporate issuers in China cluster around the 'AA' to 'AAA' range. We believe this projects an undifferentiated view of many entities' true creditworthiness. We have observed, in some cases, multiple notches of downgrade within a short period prior to default.

Chart 14

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Moreover, the coupon of five-year bonds rated 'AAA' in local market may vary by up to 400-500 basis points. This indicates that the market is seeing quite different credit risks for bonds with the same high rating.

S&P Global (China) Ratings did a desktop analysis of about 1,700 nonfinancial corporate entities using public data. The study includes all the entities surveyed in the above chart, which had outstanding ratings from local rating agencies as of Jan. 8, 2021, as well as some entities with no outstanding rating in the local market.

We find that the firms' indicative credit quality implies a much more "normal" distribution (see chart 15).

Chart 15

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Two factors largely explain the grouping of ratings around the 'AA' to 'AAA' level: Issuers engage in ratings shopping--they are more inclined to use the agency that will give them the rating they want. Secondly, regulations have in the past required high ratings for investment.

This is starting to change. For example, in May 2020, the China Banking and Insurance Regulatory Commission removed a requirement that insurance funds can only invest in banks' Tier-2 capital notes rated 'AAA', or perpetual bonds rated 'AA+' or above. In February 2021, the China Securities Regulatory Commission removed the requirement that only bonds rated 'AAA' could be sold to the public.

We also note regulators' intention to raise the standards of the domestic rating industry. Officials are creating a more unified regulatory framework for the industry to improve ratings quality. We view these steps as conducive to building market confidence and attracting foreign investors.

S&P Global Ratings believes there remains high, albeit moderating, uncertainty about the evolution of the coronavirus pandemic and its economic effects. Vaccine production is ramping up and rollouts are gathering pace around the world. Widespread immunization, which will help pave the way for a return to more normal levels of social and economic activity, looks to be achievable by most developed economies by the end of the third quarter. However, some emerging markets may only be able to achieve widespread immunization by year-end or later. We use these assumptions about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Appendix

China Is Inviting In Foreign Funds To Make Its Domestic Capital Raising More Market Driven
Reforms
October 2014 Circular 43 stated that, from January 2015, only certain LGFV bonds (for social housing, water projects, roads etc.) can be classified as government debt. Others will not enjoy any implicit government guarantee.
January 2015 Corporates: CSRC allowed unlisted corporates to issue bonds. Previously, only listed firms were allowed.
November 2016 LGFV debt: Ministry of Finance reiterated LGFV debts are not government debt. As of Jan. 1, 2015, all new debt of LGFVs was to be repaid by the LGFVs on their own.
February 2017 Hedging: SAFE allowed overseas investors to access the foreign-exchange derivatives market to hedge bond positions.
April 2017 LGFV debt: Circular 50 (April 2017) and Circular 87 (May 2017) reiterated that all LGFV debt is the responsibility of the issuer and is not government debt.
May 2017 Bond Connect launched to allow overseas investors easier access to the interbank bond market. 
July 2017 Rating agencies' foreign ownership limit abolished by the PBOC for the interbank bond market.
March 2018 Index: Bloomberg and Barclays announced China's domestic sovereign and policy bank bonds will be added to its Global Aggregate Index from April 2019, to account for 6.5% of an index tracked by US$65 trillion of AUM.
September 2019 Index: JP Morgan announced China's domestic sovereign bonds will be included in its Emerging Market Bond Index (EMBI) Global from Feb. 2020, to account for 10% of an index tracked by US$20 trillion of AUM.
September 2019 Underwriting: foreign-invested institutions allowed to obtain type-A licenses in the interbank bond market that allows them to underwrite all types of bonds. Previously, they could only obtain type-B licenses, which limits underwriting activities to deals by offshore nonfinancial issuers.
December 2019 Insurance: CBIRC lifted foreign ownership restriction on domestic life insurers from Jan. 1, 2020.
April 2020 Securities and fund management: firms' foreign ownership limits were lifted.
June 2019 Quotas for investments under the QFII and RQFII schemes were abolished.
September 2020 Integration: PBOC and CSRC announced plans to build the Infrastructural Connection Mechanism to allow investors a single point of access for both the interbank and exchange bond markets.
December 2020 Disclosure: NDRC/PBOC/CSRC announced new rules on annual/semiannual reports and prospectuses, and on companies that default on their bonds, requiring timely and regular reporting over the life of the bonds, to include information on parent groups, credit profiles, and investor protection measures.
January 2021 Penalties for due diligence failures in the Yongcheng Coal and Electricity case were issued by NAMFII to the parties involved, including the domestic rating agency, auditors, and underwriters. NAMFII
LGFV--Local government financing vehicle. CSRC--China Securities Regulatory Commission. SAFE--State Administration of Foreign Exchange. PBOC--People's Bank of China. AUM--Assets under management. QFII--Qualified foreign institutional investor. RQFII--Renminbi qualified foreign institutional investor. CBIRC--China Banking and Insurance Regulatory Commission. NDRC--National Development and Reform Commission. Sources: National Association of Financial Market Institutional Investors, State Council of the People's Republic of China, People's Bank of China, Asia Development Bank, Asia Securities Industry & Financial Markets Association, International Capital Market Association, National Bureau of Economic Research, S&P Global Ratings.

Related Research

Writing: Jasper Moiseiwitsch

Design: Evy Cheung and Halie Mennen

This report does not constitute a rating action.

Primary Contact:Xu Han, New York + 1 (212) 438 1491;
xu.han@spglobal.com
China Country Lead, Corporate Ratings:Charles Chang, Hong Kong + 852-2912-3028;
charles.chang@spglobal.com
China Country Specialist, Corporate Ratings:Chang Li, Beijing + 86 10 6569 2705;
chang.li@spglobal.com
Asia-Pacific Chief Economist:Shaun Roache, Singapore (65) 6597-6137;
shaun.roache@spglobal.com
S&P Global (China) Ratings:May Zhong, Head of Corporate Ratings, Beijing +86 10 6516 6051
Fangchun Rong, Associate Director, Beijing +86 10 6516 6063
Research Contributor:Sundaram Iyer, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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