China’s Onshore Bond Market: Managing Credit Risk
By Eleanor Hill, Editor
China is now home to the world’s second largest bond market – an interesting potential source of yield and diversification for both global and local investors. With growing opportunities in Chinese fixed income markets, however, comes greater risk. Proper due diligence and rigorous analysis of issuers are critical for understanding the true risk characteristics of onshore credit investments, so that investors may take advantage of the growing market opportunities while minimising risk.
Growing investment opportunities and challenges
China has undergone remarkable economic growth over the past two decades, helped by rapid industrialisation and swiftly developing domestic markets. Underpinning this growth have been China’s fixed income markets, which have seen a massive increase in size and scope.
Fig 1: China Credit Market Issuer Mix
Source: J.P. Morgan Asset Management; information as at 30 June 2019.
A period of interest rate liberalisation, part of fundamental financial reform undertaken during the past decade, combined with rapid financial market innovation, has increased the number of investors seeking market-driven yields, the range of Chinese corporate issuers (fig. 1) seeking funding and the variety of instruments available (fig. 2). Together, these forces have precipitated a twelvefold surge in the size of China’s onshore credit market, contributing to the depth, liquidity and vigour of the Chinese bond market today.
Alongside the significant growth in the Chinese onshore bond market, however, the risks of investing have also increased. The government’s implicit guarantee has been largely eliminated (see box 1). The credit fundamentals of some corporate issuers are weak. And domestic rating agencies’ methodologies have limitations. Together, these issues are creating significant challenges for credit analysis.
The challenges of investing in the onshore credit markets are magnified by a lack of experienced credit analysts, weak corporate governance and limited financial disclosures. In addition, underdeveloped bankruptcy laws, opaque financial links, the scarcity of cross-default clauses and limited rating actions by domestic rating agencies constrain investors’ ability to ascertain whether a default has actually occurred or what the likely recovery terms or ratios might be.
The picture is further complicated by the fact that until recently, none of the major international rating agencies (Fitch, Moody’s and Standard & Poor’s) had licences to operate in China. Nine local rating agencies dominate onshore rating. The Chinese authorities regulate the number of rating agencies and rating nomenclature. By law, bond issuers are only required to have one rating, making competition among domestic agencies intense. Operating independently from international market standards and practices, local rating agencies have developed their own methodologies, limiting investors’ ability to map local ratings to international rating scales.
This is now changing, with some international rating agencies having received licences to issue onshore credit ratings in China. While they will face the same regulatory and data quality challenges as their local peers, their entry marks a significant and positive development. Their strong reputations and rigorous rating methodologies should increase international investors’ confidence while boosting the professionalism of the domestic credit rating industry.
Against this backdrop, how can investors take advantage of China’s onshore bond market, while minimising downside risks?
Fig 2: The wide variety of Chinese credit instruments