China bonds approaching 'defining moment'

The development of China’s bond market is entering a defining period that promises to be a game-changer for investment portfolios, a forum heard recently.

At $5.5 trillion, the mainland’s fixed income market is already one of the world’s largest, although restricted access has seen it maintain a low profile.

But new opportunities are emerging, in light of the fast-developing area of corporate credit, strong issuance from municipal governments and the forthcoming addition of instruments such as asset-backed securities.

Moreover, demand for renminbi-denominated assets is also expected to surge if – or more likely when – the International Monetary Fund puts the RMB in its basket of global reserve currencies with special drawing rights (SDR).

Speaking on a panel at the annual Hong Kong Investment Fund Association forum, Bryan Collins, a portfolio manager at Fidelity Worldwide Investment, said development of China’s fixed income market should be viewed in the context of its American equivalent.

“If you think about the way the US market has developed in terms of the different funding vehicles and requirements for banks, corporates and governments, that is probably the best overlay we can project to see what China’s bond market might look like,” he noted.

“There is going to be immense growth, with bumps along the way and periods of dislocation,” added Collins. “The next one-to-two years will be a defining moment for China, but specifically for the bond market around defaults and state-owned enterprises.”

He suggested that the direct and indirect implications for Asia would be profound, particularly in light of a lower cost of funding for Chinese corporations. While he admitted there could be positive and negative consequences, overall he described it as a wonderful development for the region’s debt capital markets.

Collins noted investors had never before been able to get, in a liquid and meaningful way, a long-interest-rate exposure directly relevant to China and therefore to Asia, as Australian government bonds were highly correlated to US Treasuries and other local-currency Asian bond markets were quite “esoteric”.

He added that he would already happily refer to the RMB as the world’s newest reserve currency, describing the IMF decision on China’s entry to the SDR basket as inevitable.

At the start of the debate, Ben Yuen, head of fixed income at BoC (HK) Asset Management, had framed the China fixed income opportunity as three component parts: offshore dim sum, US dollar-denominated and onshore RMB.

He noted the dim-sum market had started to develop about five years ago and had grown to $100 billion, although half of outstanding issuance had a maturity of less than a year. Yuen added that 30-40% of issues were unrated, necessitating substantial credit research.

Meanwhile, he said China’s dollar-denominated bond market had been developing since the early 1990s and stood at around $250 billion, with more liquidity and international participation than the dim-sum market.

Finally he pointed to the onshore mainland bond market, at $5.3 trillion to $5.5 trillion in size, in which 30% of credit issuance was rated AAA.

The panelists agreed that the nature of these different opportunities and market cycles necessitated investment in all three markets, with dollar-denominated debt offering more attractive credit spreads and the onshore market significant long-duration exposure.

Stephen Chang, head of Asian fixed income at JP Morgan Asset Management, said investment boundaries between the three would start to blur, but agreed that the onshore market would be the one to gain most traction, given that it was still small relative to China’s GDP.

In response to a question from the audience on the implications for investors if the RMB were included in the IMF’s SDR basket, the panelists agreed it would cause a lot of FX reserve managers to rebalance, with yields for RMB bonds noticeably higher than for the other components of the basket (euro, sterling and yen).

“It becomes a very easy choice if you are deciding where to put your next dollar or yuan,” suggested Chang.

Collins noted that central banks were already including RMB in their foreign-currency reserves and would only be increasing their exposure.