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China’s onshore bond market is already the world’s third largest behind the US and Japan, and is still growing rapidly at around 20% a year. However, historical capital restrictions mean foreign investors hold a relatively tiny portion of the market.
The government wants to increase international investor participation in order to help deepen the bond market and support the internationalisation of the renminbi. Foreign investment in the asset class is likely to rise significantly in coming decades, driven by attractive yields, diversification benefits, the opening of cross-border capital channels such as the Bond Connect scheme and broadening inclusion of China’s onshore bonds into global benchmark indices.
Potential market size
According to our estimates, China’s onshore bond market could grow from approximately RMB 70 trillion in 2017 to RMB 280-440 trillion in total issuance outstanding by 2035 (USD 43-68 trillion based on exchange rate USD/CNY 6.5).
This projection assumes China’s bond market will grow at a compound annual growth rate (CAGR) of 4-7 per cent from 2025-2035, depending on China’s projected GDP growth rate. Within that period, China’s bond market size to GDP will be around 180-220 per cent, similar to the ratio in the US in recent years (China was at 86 per cent as of end-2016).
Source: Fidelity International, Hong Kong Exchanges and Clearing Limited, China Central Depository &Clearing Co., Ltd (CCDC), Citi, WIND, as of December 2017
The Chinese bond market has a highly concentrated domestic investor base where commercial banks hold around 60 per cent of outstanding bonds. Foreign ownership of China Government Bonds (CGBs) stands at below 5 per cent, one of the lowest among Asian emerging markets. When it comes to the total bond market, only 2 per cent is foreign-owned. That’s around USD 130 billion of onshore RMB bonds at the end of 2016. We estimate further inflows from future index inclusions of approximately USD 280 billion in three to five years. This is based on the assets under management of all the passive funds tracking the three major global bond indices (JPMorgan Government Bond Index - Emerging Markets, Bloomberg-Barclays Global Aggregate and Citi World Government Bond Index), and the weight onshore china is expected to have.
Source: Fidelity International as of March 2018. GBI-EM refers to the JPMorgan Government Bond Index - Emerging Markets. WGBI refers to the Citi World Government Bond Index.
Meanwhile, the Bond Connect scheme launched in mid-2017 has catalysed purchases by international investors. The scheme allows foreign investors to invest in the onshore bond market, while streamlining and simplifying the settlement processes. In the near-term, overseas investors will most likely focus on CGBs and high quality quasi-sovereigns. The corporate debt sector has yet to be embraced fully by international investors, who remain uncertain about onshore credit ratings, defaults, hedging and currency risk, among other things. Corporate bonds were only 6% of foreign investors’ bond holdings as of the end of 2016.
Source: Bloomberg, Bank for International Settlements, PBOC.
Risk-adjusted outperformance, low correlation with other asset classes
Given very different fundamental drivers as well as capital flow restrictions, onshore RMB bonds have shown close to zero correlation to other key asset classes around the world, making them attractive for boosting diversified portfolios’ risk-adjusted returns. For example, China bonds were relatively insulated from global market shocks such as Brexit and the US elections in 2016. We expect this divergence to persist, given different policy objectives between the Fed and the People’s Bank of China. Meanwhile, healthy yields and a lack of volatility make China bonds appear attractive on a risk-adjusted basis, in a year when most assets have showed lacklustre returns.
Source: Fidelity International, Bloomberg, ICE BofAML Bond Indices, J.P. Morgan Indices, ChinaBond, MSCI Equity Indices based on 5-years to May 2018. US 3-Month T-bill was used for Sharpe ratio calculation.
Source: Bloomberg, ICE BofAML Bond Indices, J.P. Morgan Indices, MSCI Equity Indices based on 10-years to May 2018. The table uses a linear color scale from 0 = green to 1 = red. For offshore RMB Bond, data since January 2011. For Onshore RMB Bond, data since January 2013.
Market history and road map to 2035
China’s financial reforms have been accelerating in recent years, along with the drive to internationalise its markets.
Source: Fidelity International, June 2018
The opening of China’s bond market is bringing increased transparency for investors and new funding sources for issuers in a market historically dominated by bank loans. The two main markets for transactions are the exchange traded market and the interbank market. Currently, they are effectively separate entities, with different bond listings and large disparities in volume and liquidity.
In recent years, foreign investors have been allowed greater participation in the more liquid China Interbank Bond Market (CIBM), which accounts for around 90 per cent of trading volume of onshore bonds. However, before foreign investors feel comfortable enough to fully invest, especially in corporate credit, the market needs to improve in areas like credit ratings granularity, bankruptcy proceedings and hedging tools.
Ratings differentiation and accountability
A common source of confusion is the different ratings systems between China’s domestic agencies such as Dagong, Chengxin and Lianhe, and the international ones such as Moody’s, Fitch and S&P. Domestic agencies typically give ratings between AA and AAA (over 80% of onshore bonds fall into this category). Many international observers regard them showing less differentiation and less granularity. One rule of thumb, according to a working paper from the People’s Bank of China, is to consider AA- onshore to be equivalent to BBB- on the global scale. Onshore and offshore agencies also favour different factors, such as size of assets by the former and lower leverage by the latter.
Source: PBOC working paper
China opened the domestic bond ratings market to international agencies last year. There’s demand for them to play a bigger role, but progress has been slow and the market is mostly characterised by institutional investors doing their own credit research.
Source: Bloomberg, Fidelity International, China Bond, Wind, as of Feb. 2018.
More frequent defaults and clearer bankruptcy procedures
In the past, the Chinese government was expected to step in when bonds defaulted to maintain social stability. Now, authorities want to reduce their intervention and the moral hazard it involves, opting instead for a healthier, more transparent bond market. China onshore default rates are very low by international standards, below 0.5 per cent, whereas the long term historical average of Asian High Yield (USD) defaults is around 2-3 per cent.
A gradual increase of orderly defaults, along with more clarity on workout/default processes, will broadly benefit the market. There are near-term risks, as too many defaults could lead to a sustained increase in yields, but the chance of this becoming a systemic issue is limited given the government’s controlled and cautious pace of pursuing market reforms.
Wider selection of hedging tools and platform consolidation
Most hedging products are traded only in the interbank bond market, while foreign funds and securities companies mainly use the exchange market via the Qualified Foreign Institutional Investor (QFII) and RMB Qualified Foreign Institutional Investor (RQFII) schemes. The exchange market is less liquid and much smaller, leading to higher credit spreads and weaker hedging options. We expect more hedging options for both bonds and FX, and gradual convergence of the currently fragmented platforms, exchanges and regulators. Since 2015, we have seen new supply shifting from the offshore RMB bond market (the so-called Dim Sum bonds) towards onshore bonds as the onshore bond market continues to open up and evolve.
Source: Fidelity International, Bloomberg, ICE BofAML Bond Index: CNHJ, as of February 2018.
Exchange rate should be stable/supported
The renminbi’s journey towards a market-driven, global reserve currency goes hand in hand with the onshore bond market’s development. Overseas investors watch the mostly fixed exchange rate carefully, especially any one-off devaluation risks such as in August 2015 which spooked global equity markets. Related to currency risks are any new capital controls, but policymakers appear committed to opening the market.
Longer term, the government intends to make the RMB a fully international currency, driven by market factors rather than intervention. The currency’s inclusion in the IMF’s Special Drawing Rights basket shows its growing acceptance in trade and investment. This will also bring further capital inflows which support the exchange rate. Overall the currency will likely be less volatile than before.
Source: Bloomberg; Fidelity International
A robust onshore bond market will help finance growth among public and private companies, while offering more choice for investors. Committed reforms are needed among regulators and issuers to resolve growing pains along the way and this will take years to play out.
Investors with diversified portfolios could consider adding allocations to China bonds for their low correlation to other assets which can enhance risk-adjusted returns. But diligent research is needed, as this market is still opaque and immature for its size.
Return data referenced in article