China’s Bond Market — A New Refuge?

Although the COVID-19 pandemic has imposed significant challenges on the world at large, China’s capital markets -- and the debt capital market in particular -- have been faring pretty well. The central bank reacted quickly to the COVID-19 induced market crash. Yet increased volatility and low to below zero interest rates persist, with almost 25% of the global bond market offering negative yields.

As the volume of negative interest rate bonds around the world continues to set new records, how can you exploit opportunities in China’s high yield bond market? This was the topic of a panel discussion moderated by Ricco Zhang, Senior Director, Asia Pacific, International Capital Market Association (ICMA). Speakers on the panel included Gareth Nicholson, Head Fixed Income, Bank of Singapore, Eric Liu, Director Asia Fixed Income, Blackrock, Eugene Cheung, MD & Head of China, Tradeweb, and Rebecca Weinrauch, Executive Director - Head of Fixed Income, ASIFMA.

Exploiting Opportunities For International Investment

In 2020, China’s inclusion in all three of the top global indexes marked something of a turning point for the nation, with the formal admission of foreign investors into China’s $15 trillion bond market. This is likely to signal the commencement of significant inflows of capital -- signs of which are already evident.

International investors held over 2.5 trillion yuan by the end of May 2020, representing a year on year growth of nearly 30%, and an over 10% increase since the start of the year. Currently, there are three principal entry routes for investment in the China bond market: Bond Connect, PRQB, and a direct access scheme.

In a prevailing low to negative yield environment, China’s ten-year government bonds offer an attractive nominal and real yield -- a real opportunity for international investors. Incentives such as First In First Out and fiscal and monetary stimuli are helping to sweeten the pot. As of August 2020, foreign investors were holding somewhere in the region of 7% of the China Government Bond (CGB) -- but only around 1% of the credit bond holdings.

Compared to the global alternatives, China’s credit bond market is now offering attractive yields, and is likely to excite interest from overseas investors, in future. Even a small shift of investment from international markets to China could have considerable effects.

Increasing Access To The Chinese Bond Market

A series of measures over the past few years (such as the successful launch of Bond Connect in 2017) have significantly improved foreign investor access to the Chinese bond market. These measures are making life easier for asset managers, and have been both statutory and technological. For example, through the use of APIs (Application Programming Interfaces), regulators have been able to allow interoperability between various trading platforms.

Looking ahead, China’s bond market regulators are seeking mechanisms to increase harmonisation between different investment channels, and to facilitate direct trade with international investors.

Hedging instruments to increase capabilities and reduce costs are also likely to increase access to the Chinese market. These may include FX hedging, and interest rate hedging. Measures may also be in development to enable foreign access to the Chinese government’s onshore futures market. Such moves could herald the creation of a viable trading ecosystem for foreign investment in the China bond market.

Navigating A Changing Regulatory Environment

Despite China’s ongoing geopolitical complications, the bond market continues to open at a steady pace, with a lot of engagement between the regulators and stakeholders in the trading ecosystem.

A number of 2020 initiatives have been assisting in this -- for example, a safe circular noting that investors eligible to trade in China’s bond market can use forex derivatives to manage their risk exposure. Likewise, CEFEX followed this with the launch of a live brokerage business in China for foreigners trading FX -- effectively lowering the barrier to entry in terms of collateral, and enabling more transactions to take place.

Easement measures have also been continuing along the three principal channels of access for overseas investors, with moves toward standardisation in admission requirements, and mechanisms for inward remittance and the outward repatriation of investments. New draft legislation may increase the range of bond types that international investors can trade in.

At the institutional level, the People’s Bank Of China (PBOC), HKMA, and Monetary Authority of Macau have been negotiating the Wealth Connect Fund, an initiative with implications for the future flow of both north and southbound fixed income products. As from July 2020, PBOC and CSRC issued a joint statement announcing the connection of the China inter-bank market and the exchange market, enabling qualified investors to trade bonds in both.

Moving forward, the regulatory landscape looks set to lean more towards harmonisation and the combination of different trading channels, rather than the creation of new ones.

Navigating The Risk Environment

From a geopolitical perspective, China’s ongoing trade conflict with the US, its border disputes with India, a controversial national security law in Hong Kong, and the nation’s response to recent events in Myanmar may cause certain international investors to tread cautiously before committing their funds to the China bond market.

Economic recovery from the impact of COVID-19 remains uneven across the globe, but interest in the Chinese market from other parts of Asia and Europe continues to grow. Incentives like First In First Out, China’s largely effective COVID-19 management techniques, plus its fiscal and monetary policies are mitigating much of the perceived risk. The healthy return from Chinese high-yield bond offerings is also a risk mitigating factor, along with government assistance in refinancing.

A lack of liquidity in the China Government Bond (CGB) is one of the most potent risks to foreign investment, and a source of anxiety for asset managers looking to keep track of China holdings in the global bond market. On the run bonds are quite liquid, but there remains a big gap between on the run and off the run bonds.

With many onshore enterprises having already defaulted on their debts in the years prior to COVID-19, much of the potential for default risk moving forward has reduced. So default rates are not expected to rise appreciably, in the next few years.

Risks certainly exist -- but if investors do their credit homework and exercise due diligence, there are opportunities as well.

Balancing Challenges And Opportunities Moving Forward

Greater transparency and liquidity in the China bond market are required, to induce international investors to more willingly embrace what’s on offer. Until there is more openness in evidence, the China bond market will remain the preserve of specialist investors, rather than retail buyers.

Proactive moves from Chinese regulators to ease the way for foreign investors to enter the market continue to elevate China as an attractive market -- especially given the sluggish performance of bonds in the wider global arena.