Outperforming in China’s Onshore Bond Market

If you made it to this article, then my first story on China’s onshore bond market resonated or at least made you sit up and take notice. Given the current market structure and attractiveness, I see alpha coming from three sources as this market continues to open to foreign investors:

• A steepening yield curve will drive down rates at the front of the curve
• Spreads will tighten against comparable U.S., eurozone, and Japanese issues
• Greater consistency and transparency across ratings agencies that will complement strong fundamental credit analysis

My thesis is that while western markets have been lamenting the end of a 35-year bull market in bonds for quite some time, given anticipated inflows and a lower cost of capital attributed to global investors chasing yield, we are at the early stages of what could be the golden era of fixed income investing in China. Let us address each of these sources of alpha in turn.

Steepening Yield Curve

As we can see in the chart below, 87% of bonds in the ChinaBond Aggregate Index mature in less than 10 years. The maturity profile of the onshore market lends itself to a natural steepening: 43% of issues will mature in less than three years and nearly 65% will mature in less than five years. Only 13% of issues will mature in more than 10 years. Compare this to the Bloomberg Barclays Global Aggregate, where nearly 30% of issues mature in greater than 10 years and over 40% mature in greater than seven years.

Relative Spread Tightening

An aging population in developed markets supports the notion of stable, if not increasing, demand for yield across markets. The premium identified in the previous article (130 bps, 315 bps, 356 bps relative to U.S., eurozone, and Japanese 10-year bonds, respectively) would indicate a market ripe for tightening given a solid AA-/A+/A1 issuer rating from S&P, Moody’s, and Fitch. With zero interest-rate policy seen in the eurozone and Japan and the slow unwinding of quantative easing in the U.S., the onshore market is a great place to pick up yield without sacrificing on quality (the elusive “safe spread”).

What kind of tightening should we expect? Let’s start with a 50 basis point tightening. This is less than the assumed steepening in the prior section. We can then run scenarios for any level of parallel move. See the chart below summarizing the total return seen in the ChinaBond Aggregate Index assuming parallel shifts of 50, 75, 100, and 125 bps. This analysis is most effective in understanding the broader directional implications of market moves and must be supplemented with rigorous security analysis.

Rating Agency Consistency and Transparency

One of the most commonly cited risks by western investors revolves around the consistency and transparency of methodologies used by local rating agencies. Nearly 75% of issuers are rated AA or higher, while less than 1% are rated BBB or lower. Though it’s true that defaults are at record lows (and ratings should never take the place of fundamental analysis), that disparity is eye opening. I see two potential solutions. One is the reset of local agency methodology to reflect credit fundamentals seen across non-financial corporate issuers. The second is the potential for S&P, Moody’s, or Fitch to enter the market. This may placate western investors and increase demand across issuers, given the acceptance of the big three across the institutional space.

The China onshore market presents a fantastic opportunity for investors of all types as it opens itself to foreign ownership. Local investors may be able to use this opening as an alpha-generating opportunity by extending duration to capture the roll down, complementing their fundamental analysis with broader interest rate analysis, and understanding the drivers of corporate credit worthiness. Global investors can gain diversification and yield pickup by analyzing the market and how it fits into their portfolio today.