Much has been said about the sell-off in sovereign bonds which led to 10-year yields breaking through the 4% level in onshore Chinese bond markets for the first time in three years (on 14/11/2017).
Despite this sell-off we are constructive on parts of the onshore Chinese bond markets in the medium term. In our view, most current market fears are overdone. This positive view on government bonds is, however, coupled with a negative view on onshore corporate issues.
Four percent is by no means a meaningful psychological threshold. Ten-year Chinese government bond (CGB) yields have broken above this level several times already, for example, in 2014. We do not consider 4% a ‘fear’ threshold (see Exhibit 1).
Exhibit 1: Changes in the yield of Chinese 10-year government bond yields, 2013 – 17/11/2017
Higher yields reflect genuine concerns on the part of domestic investors
- Inflation fears have recently re-emerged after quarters of denial by market participants as the recent rebound in producer prices, which was originally seen as temporary, is now considered more sustainable (see Exhibit 2). Over time, we expect inflation to gradually pick up and the central bank’s monetary stance might have to remain tight despite slower economic growth. It is, however, unclear to us whether the People’s Bank of China’s (PBoC) preferred monetary policy tool is interest-rate rises or further administrative measures.
Exhibit 2: Changes, year-on-year in China’s producer price index (PPI), 2011-2017
2. The process of reducing debt is real and could start to have a meaningful impact on the economy. On the one hand, markets perhaps overreacted to concerns over additional regulatory constraints on the banking sector. On the other hand, the latest communications from the PBoC as well as other regulatory bodies have been clear about the need for deleveraging given the alarming amount of debt in the system.
3. Investors are well aware that any further tightening of key rates by the US Federal Reserve is likely to have ripple effects on all markets, including those, like China, which are more idiosyncratic. While it is unclear to us how the potential for higher US Treasury yields will ultimately translate into higher yields in China, there are nonetheless concerns within China that the country will not be immune to higher global rates. China is, after all, not an island.
Turning point for onshore Chinese bond markets
All these fears are valid and contain some truth, in our view. For example, we agree that the economic slowdown in China will not trigger monetary loosening, but we believe it is too early to bet on this. Instead we could see both slowing growth and monetary policy remaining relatively tight.
Markets are, nonetheless, getting closer to a turning point, for several reasons:
- First, we do not think that the macroeconomic story is tangibly improving and market fears of inflation surprising on the upside are therefore actually misplaced. Hence we do not think the odds are high that ‘good’ macroeconomic news will translate into ‘bad’ news on the inflation front.
- Second, while we do believe that policymakers are serious about reducing debt, we think they are committed to striking a balance between a) the need to reduce debt and to inject some credit risk into the system through increased onshore Chinese bond default rates and b) the necessity of avoiding the creation of systemic risk in the system. Gradualism, as always in China, will likely remain the key word.
- On the issuance side, we see little risk of a surprise increase in the issuance of government bonds. Just the opposite, in fact. While we are concerned about overall fiscal risks in the longer term, we see little supply risk in the short term and domestic demand should remain strong, especially if the A-shares market enters into a consolidation phase after what has been a ‘one-way street’ rally. We believe domestic institutional investors will remain buyers of their own market.
- Importantly, we believe it is best to not fight foreign flows. Next year is likely to be a memorable one as we expect China to be included in both global and emerging market fixed-income indices. This inclusion could trigger significant inflows; by our own calculations, around USD 200 billion. China is the most under-owned market globally with the share of foreign ownership at below 2%, compared to Japan and South Korea, where ownership is in excess of 10%. Emerging markets such as Indonesia have shares of foreign ownership at around 40%. We do expect the percentage of foreign ownership in China to increase significantly over time as investors become more comfortable with renminbi risk and yields remain appealing compared to those of developed markets. Policymakers have recently made great efforts to streamline the regulatory environment, lifting all access constraints and alleviating settlement and tax concerns.
Constructive on onshore Chinese bond markets
Consequently, despite all the negativity in the market, we are constructive on onshore Chinese bond markets. There are limits, however. We are positive only on government bonds as we still see some significant risks for corporate bonds.
The price discovery mechanism for corporate bonds is far from optimal: credit risk is priced far too much from a ‘top-down’ perspective (i.e. based on the likelihood of government bailouts), rather than from a ‘bottom-up’ perspective (i.e. based on standalone credit fundamentals).
Onshore corporate default rates will likely pick up. While this is healthy and good news in the longer term, the legal and regulatory environment has yet to be tested.
So overall, after years of ‘lazy carry’ (remember the “yield pick-up over the sovereign” story for adding a bit of credit risk), running credit risk in onshore Chinese bond markets is not healthy in the short term. We see much more price differentiation taking place in future quarters. Hence we are cautious on corporate bonds, but more constructive on government bonds.
Written on 21/11/2017
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