Year of the Rat Outlook: Will there be any bond market shocks?

Every Chinese New Year, AsianInvestor makes 10 predictions about developments that will affect global financial markets and the portfolios of Asian investors, especially asset owners. These developments can focus on asset classes, geopolitical events, or structural issues surrounding particular markets. 

For this outlook we consider the possibility of unsettling news causing major disruption in the world's bond markets. 

Will there be any major bond market shocks?

Answer: No (but China could be vulnerable) 

Overall speaking, the global economy seems to be some distance away experiencing a new bond market upheaval. Geopolitical risks appear to have tapered off, leading central banks have largely held their monetary policies steady, and the increase in debt-to-GDP levels of both developed and emerging economies have been modest.  

According to the International Monetary Fund, the global debt ratio in 2018 only showed a small uptick over that of 2016.  

But that doesn’t mean there aren’t any pressure points. 

Behind this relatively sanguine outlook are some concerning statistics. Both public debt ratios and corporate debt ratios of advanced economies are high, with the latter now treading on the same level as in 2008. The IMF warned of a liquidity shortfall in around 15% of some 1,760 bond funds it had examined, should market volatility increase. The total sample size represented about 60% of the $10.6 trillion global outstanding fixed-income assets.  

As asset owners continue to look for higher yielding instruments in the current low-rate environment – which also looks to persist for the rest of the year at least – they would do well to be cautious of the bond market in China in addition to the points made above. 

The country’s sizeable total debt ratio stood at 258% of GDP at 2018’s end. That was on par with that of the US, and a level that might not scare investors off. In addition, Beijing's its efforts to improve credit quality should also be appreciated as China seeks to internationalise its market. 

But the possible impact of the recent Wuhan coronavirus outbreak has somewhat complicated matters, prompting worries over China’s already slowing growth rate, and the acceleration of its bond defaults. Its GDP had already slowed to 6.1% in 2019, the slowest pace in 30 years.  

With the virus raging in the country, inland and international travel have either been halted or reduced by related authorities to contain the outbreak. This will inevitably deal a blow to multiple sectors including transportation, retail and tourism, setting off a ripple effect that dents the local manufacturing industry, consumption, and in turn, Chinese corporates’ earnings and their financial health. 

The question then becomes: will China bail out ailing companies who can’t meet their repayment obligations? It is possible but unlikely. Beijing has already begun to show a higher tolerance to corporate defaults as the country's authorities attempted to rein in debt levels.

Worse still, less borrowers in default are making principal or interest payments to bondholders, with the number of them doing so having dropped from 46% in 2016 to 13% last year. 

While laws are in place to protect investors when borrowers declare bankruptcy, they don’t always do. The Financial Times reported that China’s local courts would rather rule in favour of defaulters with a major role in the economy than back their investors.  

With these issues in mind, the corporate bond part of China's $13 trillion bond market does look vulnerable. And with the country having further opened up its capital market to global investors who wish to enter, any shock waves sent by this market would surely be felt well beyond the country's borders.