Are Chinese corporate bonds presenting opportunities following the Covid-19 sell off?
Cheaper valuations following the Covid-19 crisis and broadly supportive economic and company-level fundamentals make an appealing case for Chinese corporate bonds.
The Chinese corporate bond market has grown significantly in recent years, and is on course to become one of the world’s largest credit markets.
The pandemic has slowed the Chinese economy, but to a lesser extent compared to developed economies. Chinese GDP is expected to remain positive at 2% in 2020, with growth forecast to recover strongly to 8.6% in 2021.
Chinese policy makers have been less generous than others with monetary easing and fiscal programmes. This is to ensure they avoid inadvertently unwinding the de-leveraging campaign conducted successfully over the last few years. The credit boom after the 2008 Global Financial Crisis contributed to increased debt levels in China, mainly driven by corporate borrowing. For several years now, the authorities have been determined to keep debt levels under control.
One of the positive signs is that broad shadow banking assets (lending taking place outside of the regulated banking system) relative to GDP have fallen in the past four years. Overall, leverage will inevitably rise in the medium term as monetary and credit policies are eased to support economic recovery from Covid-19. We think the increase will be limited though, and do not see systemic risks as there is clear intention by policymakers to continue to focus on financial stability.
Over the last decade the composition of the economy has shifted from manufacturing and exports to domestic consumption and services. With less dependence on global trade to fuel a domestic recovery combined with a greater policy focus on controlling debt levels, the aggregate economy is more robust and resilient overall.
These macroeconomic fundamentals remain, in many respects, supportive for bonds, while valuations have become more attractive. As such, might we be witnessing an opportunity to gain access to a burgeoning and appealing market?
How attractive are China’s corporate bond valuations?
Chinese corporate bonds sold-off sharply, like other markets, at the height of the Covid-19 crisis. Both investment grade (higher quality, rated BBB and above) and high yield (which are considered riskier) were impacted.
As we can see below, the credit spread of US dollar-denominated Chinese investment grade corporate bonds rose from the mid-February level of just above 130 basis points (bps) to 286bps in the latter stages of March. As markets have recovered, the China investment grade credit spread has come back to around 220bps, still materially above levels seen over the last few years.
A large proportion of the US dollar investment grade Chinese bond market comprises state owned enterprises and banks with implicit government support, which has helped it to remain resilient.
China high yield credit saw a sharp decline with the spread reaching levels not seen since 2011, the last episode of heightened market panic, the “Taper Tantrum”, when the Federal Reserve began reducing Treasury purchases.
From below 600bps on 20 February, the spread blew out to around 1500bps at one point. High supply of new bonds and lower liquidity partly explains this. Government-supported, quasi-sovereign companies also contribute to the lower emerging market spread. In aggregate, China high yields looks attractively valued, but we see the market as attractive on a selective basis.
China's corporate bonds have shorter maturities
A notable characteristic of Chinese corporate bonds is their relatively short average maturity (the time after which the bond is fully repaid). Based on ICE BofAML data, the average maturity of Chinese investment grade corporate bonds, US dollar denominated, is just under six years, while the aggregate market yield was 2.6%, as at mid-June.
Investment grade emerging market corporate bonds (US dollar), based on the JP Morgan index, had an average life of 8.5 years, with a yield of 3.6%. US investment grade credit has an average life of 11.5 years and a yield of 2.2%. If we compare similar maturities, the US investment grade 5-7 year corporate bond index yields 1.8% and 5-7 year emerging market corporate bonds has a yield of 3%.
As a result, China has lower duration, or sensitivity to interest rates. The shorter maturity, broadly amounts to a lower level of risk. A longer maturity, effectively means a greater level of uncertainty, since it increases the scope for something unforeseen to occur.
Is the downgrade cycle bottoming out?
Ratings agencies have been much more proactive in issuing downgrades than in the past, such as during the 2008 crisis. In response to the crisis, the level of upgrades to downgrades has reached an all-time low. This round of downgrades largely reflected the worst-case scenario, in the wake of Covid-19.
Downgrade risks still linger as the Covid-19 pandemic is far from over, and corporate earnings will remain under pressure. However, given massive fiscal and monetary policy support as well as lockdown easing, we do not expect to see the same breadth and magnitude of downgrades as was seen in April and May. The risk to that view is a large second-wave of infections that triggers re-imposing of widespread city lockdowns and/or a relapse in oil prices.
Against the backdrop of deteriorating credit fundamentals, performance in the credit markets is likely to be uneven and active management has become more important than ever.
Do downgrades mean higher default risk?
The large amount of credit growth over the past decade in China and the resulting “problem” assets is a key issue that policymakers have rightly been taking steps to address. 2016 marked the end of what was essentially a credit boom (mainly driven by corporate borrowing) in China following the Great Financial Crisis. Since then, policy has shifted direction notably toward limiting leverage growth.
Leverage will increase, across all types of borrowers in China in 2020, to counteract the impact from Covid-19. However, credit “clean-up” remains a priority for policymakers. They will in all likelihood allow more defaults to occur in a controlled manner as problem credits emerge, albeit providing stronger support if required to avoid systemic concerns.
To us, there is a clear intention among policymakers to continue to control the amount of debt in the economy and be increasingly selective in bailouts. Bond market defaults have risen in China in recent years. The default by the Tianjin-based Tewoo Group, a high-profile state-owned issuer, late last year underlines this. More are likely as the fall-out from Covid-19 becomes apparent.
Longer-term, this can have positive effects. A greater willingness to allow defaults could help reinforce more disciplined corporate behaviour and balance sheet management, though many Chinese companies are in a solid position already.
As we can see below, Chinese investment grade companies have fostered strong balance sheets. Among high yield, there is more scope for improvement, but here companies with good balance sheets and fundamentals can be found.
In addition, compared to some other emerging markets such as Latin America and Africa, the China credit universe has much lower exposure to crude oil, so is expected to be more resilient to weak oil prices.
China is also less exposed to the disruption to tourism, compared to other Asian countries such as Thailand, and has better control of the pandemic compared to countries such as India and Brazil. As such, Chinese companies are broadly on a better footing to weather the impact from Covid-19.
China’s corporate fundamentals remain solid
Top-down fundamentals remain supportive
In an extremely low interest rate environment, income is increasingly difficult to source and Asian credits offer attractive yields for the level of risk.
With continued downward pressure on earnings, and China’s authorities likely to tolerate a higher default rate, it will be important to identify those stronger businesses, which can survive and thrive.
Additional liquidity has poured into the market, which has and will probably continue to push risk assets higher, indiscriminately. The market recovery following the Covid sell-off, saw almost panic buying in Asian credit markets. As we emerge from the Covid-19 crisis we expect increasingly divergent credit fundamentals to be reflected in markets.
We also expect structural changes from Covid-19, such as in consumer behaviour and supply chain management. As a result, the credit outlook will vary among different industries and depend on how companies adapt. We think an increasing focus on sustainability will be a prominent aspect of how companies and governments adapt.
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