Following last year’s September sell-off, valuations in European high-yield (EHY) are looking attractive once again. Volatility is to be expected in the short term, but the asset class has proven its worth in testing economic times.
Over the past year, officials have expanded the types of foreign investors who can invest in the so-called China Interbank Bond Market. They have also removed investment quotas, cut red tape and scaled back restrictions on capital repatriation. Foreign ownership– mainly in government bonds and debt sold by the state-controlled policy banks –accounts for only 2 per cent of the $7 trillion onshore market.
Until now, the easiest way for foreigners to gain exposure to Chinese credit has been to buy bonds that are denominated in a foreign currency and sold outside mainland China; or to invest in yuan-denominated bonds sold in Hong Kong – in the so-called ‘dim sum’ market.
By giving foreigners greater access to domestic bonds China hopes to create an alternative source of funding for its companies, relieving the burden on banks, as well as offsetting capital outflows.
The ultimate sign of international investor approval will be the inclusion of renminbi-denominated bonds in benchmarks including the JPMorgan Emerging Markets bond indices and the Citi World Government Bond Index. A decision is expected soon.
Approval is expected to attract some$155 billion of passive funds into the onshore bond market, the world’s third largest, in the same way the anticipated addition of Chinese A-shares into MSCI’s Emerging Markets Index will help siphon international money into local-currency stocks.
Active funds will be more circumspect because US dollar bonds sold by Chinese borrowers offshore tend to offer better value than their corresponding onshore local-currency debt, especially with the additional yield investors receive – the so-called ‘carry’ –in a currency swap from dollars to yuan.
This is even more true since Donald Trump’s election victory pushed Treasury yields higher amid expectations of faster US interest rate hikes. Returns jump significantly when the currency factor, plus a weakening renminbi and surging dollar, is taken into consideration.
For example, a 10-year dollar-denominated bond that’s rated single A minus yields some3.5 per cent, around the same as the yield on a 10-year domestically-rated triple A renminbi bond – the equivalent onshore credit. However, when dollar-denominated yields are swapped back into yuan, investors receive an additional 2 to 3 percentage points annually.
But if that’s the case, what needs to change to attract buyers onshore? Better pricing for one thing. Until recently, investors assumed bonds enjoyed implicit government guarantees because most borrowers are government-linked to some extent; domestic rating agencies reinforced this illusion of safety by assigning top ratings to all but a handful of borrowers.
Indeed, there had been no bond defaults due to government intervention up to last year. But since then, more than ten bonds sold by state-owned enterprises have been allowed to fail with further defaults linked to private sector borrowers. While some have been resolved by the eventual repayment of principal, others are still awaiting resolution.
In future, rigorous credit assessment will take on added significance – bad news for passive funds, good news for active managers –because clearly not all borrowers are created equal, and not all state-linked companies will be considered ‘strategic’ from now on.
State-owned companies deemed to serve a public or national interest – in telecoms, infrastructure, oil and gas – will continue to enjoy government guarantees. At the other end of the spectrum, so-called ‘market competitive’ (government-linked) firms – in property, chemicals, consumer manufacturing – will be expected to make their own way in the world. In between is a lot of ambiguity.
China’s debt – an intricate web connecting government-linked businesses, state-controlled banks and the bond markets –is a big issue these days. That’s because the government flooded the financial system with credit after the global financial crisis. Most of it ended up providing life support for inefficient and uncompetitive businesses. Some of it, for example in the opaque world of shadow banking, is only loosely regulated.
Combined corporate, household, government and bank debt rose from 164 per cent of GDP to 247 per cent between 2008 and last year. Nobody really knows how much of this may go bad: estimates range from nearly 7 trillion yuan to some 23 trillion yuan. That’s around$1 trillion at the lower end of these estimates, or 10 per cent of China’s $10 trillion economy.
That’s not to say we think a debt-induced meltdown is imminent. There are a number of reasons for suggesting officials are still on top of things, not least of which is the relatively small amount of debt – some $150 billion –that’s denominated in a foreign currency.
Even though economic and financial market stability are dependent on government stimulus and corporate productivity is declining, as is profitability, in the worst case scenario China can print money to honour renminbi debt obligations although this will create currency risk for foreign investors.
The inclusion of Chinese bonds in international benchmarks is something that a lot of people are looking forward to. It’s one step closer towards integrating Chinese capital markets into the global financial system, mirroring China’s central role in the world economy. However, navigating the growing risks is where fund managers will really earn their pay.
Ben Pakenham, Deputy Global Head of High Yield, Fixed Income
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