Chinese Bonds Following the Trail Blazed by Equities
By Kevin Smith
I recently wrote about my experiences of investing in equities in China over the past 25 years (see here). Bond markets in China are now following a similar path of being made available to international investors. The Bond Connect programme celebrated a first anniversary in July 2018 with some impressive transaction flows achieved during that year. Caution is required when looking at the bond market in China, however not sort of the caution that is typically expressed by headlines in the media which tend to focus on rising rates of default. We view the recognition of defaults as a positive development, unsound companies should be allowed to default. The default rate in China is too low to be believed so we view the recent rise as a sign of progress not crisis. Investing in Chinese bonds today has parallels with investing in China B-shares 25 years ago, it is a step into the unknown and there will be some lessons to be learned.
Unlike the equities counterpart, Bond Connect offers only a “Northbound” component to the programme, international investors looking to direct investments into China. There is no equivalent “Southbound” route for domestic Chinese investors to access international bond markets. The introduction of Bond Connect was taken by some global investment managers as an opportunity to sell the idea of investing in Chinese bonds based around two elements, market size and a yield premium versus many other markets in the world. At the end of June 2018, the total amount invested via the Bond Connect programme was equivalent to USD 224 billion, an increase of international participation in the market by 75% since the scheme commenced in July 2017. International investors now hold 2% of the domestic corporate bond market in China.
The number of companies defaulting on their bond repayments is increasing, 13 companies (4 listed) in the first half of this year versus 18 (1 listed) in all of 2017. This increase is to be expected in direct response to steps taken to tighten credit conditions in the economy and an increased acceptance of defaults by the authorities. The acceptance of defaults is a step in the right direction and marks a significant change from the historic policy of implicit guarantees applied to all debt securities. We particularly like the fact that listed companies are being permitted to default. Debt defaults were allowed to occur for the first time in 2014, so that aspect of the market is still very immature.
The net result of allowing defaults will be improved capital allocation and efficiency. The transition however will be a sometimes-painful learning process for the market participants just as it was in the equity market 25 years ago. Domestic credit ratings need to adjust to a market that allows defaults. According to domestic ratings agencies nearly 30% of the Chinese corporate bond market is graded triple-A versus 2.2% for bonds rated triple-A in the United States. The ratings illusion needs to be appreciated as a key element for any international investor participating in the corporate bond market in China. Most corporate bonds in China are speculative rather than investment grade paper and that should be reflected in the ratings being awarded in the domestic market. That adjustment process to realistic bond ratings will be slow.
While bond defaults are now accepted in China, the default rate is less than 0.1% versus the global average of 2.4% in 2017. In the next few decades we should expect to see the default rate rise in line with international norms. With the equivalent of USD 1.3 trillion of bonds due for repayment in the next twelve months, you can expect to see another step up in the default rate especially as the short-term fix of financing via the shadow banking sector has been (correctly) stamped out by the authorities. The next time you see a headline in the media expressing concern about rising defaults in the Chinese bond market, try to react positively remembering this is a sign of progress.