Investing in China: Exposure on the Chinese debt markets
Strong case to get exposure on the Chinese debt markets
The Chinese bond market is a fairly recent asset class for European investors, and can be split in two groups. Firstly, the onshore market in local currency weights around 16 trillion USD, which makes it the second largest bond market in the world. And secondly, there is the offshore credit market in dollar, which is now larger than the European high yield market. “They are simply too big to ignore for global bond investors”, points out David Cheng (Investment Director for Asian fixed income at Schroders).
Strong inflows
“Both onshore and offshore markets offer attractive valuation with diversification benefits. They're both growing with solid fundamentals”. Over the last 10 years, the size of onshore bond market has been multiplied by five. At the same time, the offshore credit market barely existed at all, and now weights 600 billion USD with about three quarters of the market in investment grade bonds in one quarter in high yield credit, split mainly over three sectors: financials (26%), real estate (24%) and quasi-sovereigns (26%). “This split is quite different from the other main credit markets, with very little exposure to oil and mining, or to sectors which have been very sensitive to the pandemic. This explains the strong performance of the Chinese credit market in March 2020”.
The process of opening up the Chinese bond markets to foreign investors has been ongoing for several years, and has resulted in an increased representation in the main international bond indexes. “Since 2019, international investors also have a more direct access to the onshore bond market, which has driven lots of capital flows. The first spike happened in 2018, when sovereign central banks and institutional investors anticipated the inclusion of Chinese bonds in international bond indexes. And more recently, we have seen monthly inflows ranging from 10 to 30 billion USD, due to the attractive yield levels compared to the global fixed income markets”.
Economic tailwind
Despite these strong inflows, David Cheng points out that foreign investors still owns less than 10% of the Chinese government bonds, less than 3% of the overall China fixed income market, and close to nothing in segment like corporate bonds and local government bonds. “We expect additional foreign flows into China, with an economic growth that has remained positive in 2020 and which is set to keep on growing quite rapidly over the next few years. China will stay the main driver of the global GDP growth for the years to come, and we expect it could potentially be the world's biggest economy within the next 10 years”.
Another argument favouring the Chinese bond markets is the currency. “We think the renminbi is likely to benefit from the depreciation of the US dollar. The United States has embarked on a significant stimulus spending program, which in turn ballooned the budget deficit as well as the negative current account balance. Historically, the US dollar and the US twin deficit have really moved together. This environment should benefit the performance of the local currency bond market”.
Mild risk
“At this point, we believe that the risks are still skewed towards a continuing depreciation of the US dollar and stable interest rate in China. The central bank will be quite careful in its monetary policy, and that rising interest rates is not a near term concern”. David Cheng also outlines that the government debt market remains mainly denominated in local currency, with only around 2% in hard currencies. “Unlike other emerging markets, China is therefore not subject to external funding pressure, and the government debt to GDP ratio remain much lower that other major economies at around 50%”.
And on the other side, the default rate has remained quite stable around 1,5%, with the rate of private companies going down while the rate of state sponsored entities going up. “This is a healthy development as policymakers are trying to minimize the implied government backing. Therefore, we can now really evaluate the bond market and the credit market based on the credit worthiness and not based on the implicit backing by the government. Investors are starting to differentiate credit quality, and this is a healthy sign of a maturing debt market. The relative value is even more compelling on the offshore credit market”.
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