December 2019

China bonds: Dining at a global bond buffet

Asian_foodIn 2019, global money poured into assets perceived to be safe, from US Treasuries to gold. Much of the flight towards quality trades has been driven by the escalating trade war between the US and China, writes Romil Patel. Investment markets performed well in 2019, with global equities returning more than 20% and a positive picture for fixed income, with global bonds and credit returning around 10% (as of October 31, 2019). The figures are even more impressive when turbulence from a global economic slowdown and major political developments, such as a record number of elections in G20 countries since 1958, are considered. But with 2019 closing with low yields across bond markets, where are investors gazing for good opportunities? According to HSBC’s latest Asian Bond Investor Survey, 96.6% of global investors are planning to increase their exposure to the Asian credit market over the coming year and infrastructure and utilities (95.5%), transport and logistics (75.3%) and technology and telecoms (86%) are all identified as popular sectors. In the Asian bond market, current price fundamentals still reflect good growth opportunities for investors. “Asia will have a better growth outlook with a relatively stable exchange rate and inflation – that’s what the bond market is telling us,” says Steve Lee, head of China and Taiwan at HSBC Global Asset Management (GAM), adding the Asia high-yield story presents a significant yield pick-up for investors compared to high-yield elsewhere. “Asia high yield bonds also have a much shorter duration compared to other developed market high yield bonds,” says Lee. “Clearly, these are the areas attracting investors to look at the Asia credit market overall and especially the Asia high yield market.” When it comes to Asia investment grades versus their US counterparts, the yield and credit spread is almost similar, meaning there is no clear advantage. On the other hand, the high yield space offers significant yield difference and credit spread and a shorter duration, prompting serious consideration from an overall Asia credit perspective, according to Lee. As a whole, China accounts for around 60% of the Asian credit universe and upon closer examination of the composition of the Asia high yield bond market, more than 60% of the issuers in this space are Chinese corporates, says Gordon Ip, chief investment officer for fixed income at Value Partners. But what are investors showing an appetite for? ‘National players like portfolio managers’
China bonds, both investment grade and high yield, have returned 12% on average year-to-date, according to the JP Morgan Asia Credit Index as of October 31, 2019. “The investment grade segment of the market benefited from a rally in US Treasuries,” says Christina Bastin, portfolio manager at Muzinich & Co. “High yield bonds performed well due to receding refinancing risks compared to the tighter liquidity conditions of the final quarter of last year.” Within China’s credit bond sector, investors are opting for high yield property names – particularly the large developers with better funding channels, including overseas issuance. Often these large developers have a huge lending bank, which positions them to benefit from future urbanisation and development in their local city. What’s more, notes Lee, larger property developers will also profit from consolidation, given that government tightening on the property sector varies from city to city, and a large nationwide portfolio will enable them to weather the tightening control while smaller players feel the squeeze in the medium to longer term. But these players also provide another benefit, according to Arthur Lau, head of Asia ex-Japan fixed income at PineBridge Investments. “We do not like regional property developers, we like national property developers. National players are just like portfolio managers – they have different portfolios and projects across the country. Some projects can sell well, and others will not,” says Lau. “In a nutshell, on balance, they are more diversified in terms of the risk and as a bond investor, we like to see a company that has lower inherent business and operations risk, so those national players tend to be able to demand a better price when they issue bonds.” Some credit investors prefer to invest in asset-heavy companies, which explains a large holding in property exposure – because those are the companies that have buildings, land and apartment rent. “In case things go south, the recovery value will hopefully be better, so we like an asset-heavy business model,” says Ip of Value Partners. “For a company running a more cashflow-type model, we have to make sure that the business model is doable, that there is a high barrier of entry and that the bond will reflect the risk-reward for the company,” he adds.
Not all SOEs are equal While investors are identifying value in Chinese corporate bonds, be they state-owned corporates or private companies, not all state-owned entities (SOEs) are equal and some are better quality than others, meaning investors must do the credit work, warns Bastin. “The same applies to high yield – you can have two issuers both offering double-digit yields, but one may default,” she says. “While this may appear obvious, it comes down to a simple truth – China’s investible universe is huge, but the country and its corporates are complex.” The highest level of SOEs, the strongest, report directly to the central government, but as you go down the levels of credit, quality varies, with local government financing vehicles (LGFV) sitting at the bottom. That level requires more intensive work from investors because those are associated issuers with one province, one local town, one city in China. Distinguishing between the good and bad ones is crucial – and partly explains why some investors shy away from them. For some, LGFVs present opportunity. “LGFV bonds are particularly appealing from an investment perspective at present, especially the high yield LGFV bond,” says Jeffrey Qi, a senior portfolio manager and head of fixed income at E Fund Management in Hong Kong. “Until the third quarter of 2019, high-grade LGFV bond was the most well-performing bond, but recently the spread was too narrow, which will push the market to sink down the credit.” Phasing in access
Since 2017, foreign investors have been able to access US dollar-denominated China government bonds after the Chinese government returned to the dollar bond market after a 15-year hiatus. In late November 2019, China issued $6 billion of US dollar-denominated sovereign bonds, making it the largest offering by an Asian sovereign issuer to date, according to Javier Arias, analyst, manager research at Redington. In April 2019, the Bloomberg Barclays Global Aggregate Index started a 20-month phase of incorporating yuan-denominated China Government Bonds and policy bank notes into its constituents. This is expected to lead to approximately $150 billion of passive inflows during this period and upon completion, the country will constitute approximately 6% of the benchmark. “The inclusion to the Global Aggregate Index has attracted a significant amount of foreign inflows into yuan-denominated bonds, both from investors who are benchmarked to the index and from non-benchmarked investors. This amount will only increase once the Emerging Markets Local Currency Index begins the inclusion of Chinese government bonds,” says Arias. Within the hard currency segment of the market, Muzinich & Co sees a positive contagion effect from the Global Aggregate Index inclusion, such as increased demand for local government financing vehicle paper and increased demand for solid, state-owned entities. “While we believe the inclusion will be gradual, the key is the increased awareness of China’s part in global financial markets,” says Bastin. “Therefore, we believe all investors need to think about their China positioning, whether in local currency or hard currency.” From February 2020, the JP Morgan GBI-EM index, which tracks emerging market bonds issued in local currency, will also begin adding domestic Chinese bonds. This inclusion will start with a weighting of 1%, rising to 10% by the end of the year. As China’s policymakers continue to gradually open the country’s markets, demand for the onshore bond market from international investors is expected to rise and they are likely to go into spaces based on index inclusion. China also offers investors lower correlation to other markets given its centrally-run economy, which provides an investment advantage in turbulent times. “China’s zero correlation with developed bond markets, which is China’s yield correlation to the global index, is 0.29 versus 0.83 for the US. This offers global investors a significant opportunity to diversify risk,” says Qi of E Fund Management.
“The current level of absolute yields in China’s bond market – whether ten-year risk-free sovereign bonds or the various types of credit bonds – is noticeably higher than other major economies around the world.” ©2019 funds global asia

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