China’s rapidly expanding $15tn mainland bond market offers some tantalising prospects for pension funds and other institutional investors that have seen sources of income decline and disappear from their traditional hunting grounds in the US and Europe.
But a thicket of legal, regulatory, and trading risks lies ahead for international investors, according to the IMF, which has warned that the world’s second-largest fixed income pool requires sweeping reforms to raise standards.
Low liquidity and a shallow market present fundamental problems. Regulatory restrictions mean that domestic commercial banks, the most important owner of onshore bonds, tend to hold bonds to maturity. This reduces liquidity in the secondary market, leading to higher trading costs.
“Apart from government bonds and bank policy bonds, liquidity in other segments of the market remains poor. However, this will improve with time as the market grows in terms of breadth and depth,” says William Xin, head of fixed income at Eastspring China, the Asian asset manager.
Efficient price discovery has been weakened by the lack of a deep liquid benchmark yield curve. US Treasury issuance is focused on specific maturities, such as 10- and 30-year bonds, known as “key tenors”. But China issues government bonds across a broad spread of key tenors. This complicates trading strategies including curve trades and cash bonds against futures which help to enhance liquidity and price discovery in US fixed income markets.
The vulnerability of China’s internal bond market to adverse shocks is also greater because turnover tends to depend on whether the central bank is easing or tightening monetary policy. Risk management processes are complicated by limited access to repo markets and derivatives. Facilities such as bond borrowing, forward and interest rate swaps can be used by foreign investors only if they can prove these are to manage risks. Nor are foreign investors allowed to trade bond futures. “Foreign investors do not have sufficient derivative tools to hedge against exchange rate risk, interest rate risk and credit risk,” the IMF noted in a review of the market.
Bond defaults by Chinese issuers were unknown before 2014. But the state’s willingness to bail out state-owned enterprises and local government financing vehicles has generated a deeply entrenched system of implicit guarantees for lenders, leading to excessive risk taking and capital misallocation.
Calls for reforms face resistance, not least from lending banks which would be forced to increase their capital buffers against losses on bad loans.
The default rate in China’s bond market, which is much lower than other international markets, is expected to rise but how far is unclear. Eastspring believes the default rate will rise from about 0.7 per cent of issuance this year to between 1.2 and 1.5 per cent in 2021, reflecting the impact on lenders of slower economic growth as a result of coronavirus and trade tensions between Washington and Beijing.
Yet continued government support for an implausibly low default rate will raise more questions about whether credit risks are priced appropriately and about just how determined Beijing is to shift away from implicit guarantees. Bond ratings are another problem. Local credit rating agencies rate the vast majority of corporate bonds as AA or AAA, similar to China government bonds. This positive skew underestimates the risks compared with bonds issued in markets outside of China where ratings take a more realistic view of potential defaults. Chinese bond issuers pay for ratings themselves, a clear conflict of interest. “China’s rating industry needs to rebuild credibility,” said the IMF.
Further complicating matters is the fact that the oversight of rating agencies is split between different regulators depending on the type of bond issuer. More competition from international rating agencies is expected to improve standards but this process is still at an early stage. Standard and Poor’s entered China in 2018 and Fitch obtained a rating licence for some bonds in May 2020; Moody’s has not yet begun operations.
Tax presents more roadblocks. The government announced a three-year exemption from withholding tax and value added tax (VAT) on interest earned from onshore bonds by foreign investors in late 2018. But it is unclear which fixed income instruments are covered by the exemption. Tax regulations have proved difficult to interpret, leading to uncertainty in the calculation of tax bills and collection among foreign investors, according to the IMF.
It is also unclear if the tax exemption, which is due to expire in 2021, will be extended. “We don’t know yet if the tax exemption will lapse or not, but I expect that China will retain a friendly attitude towards foreign investors. Beijing knows that it has to be competitive against other bond markets,” says Stephen Chang, a portfolio manager at Pimco in Hong Kong.
Another longstanding concern among foreign investors is whether their ability to withdraw capital might be restricted in future. Further liberalisation of China’s capital account will be needed to ensure that foreign investors feel confident that they can exit the bond market without any hindrance, said the IMF.
None of these difficulties have deterred investment banks and asset managers from promoting China’s bond market. “International investors cannot afford to ignore the growing investment opportunities in China’s rapidly developing bond market,” says Mr Xin.
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