The DIY approach to China bond investing

Lack of international ratings means foreign investors will need research resources of their own

Most bond index providers have started to acknowledge China’s efforts to open up its financial markets, and it is only a matter of time before the nation’s debt is included in global benchmarks. That brings with it an opportunity and a big challenge for investors.

All of which means now is the right moment for money managers to put together the building blocks to be successful in the world’s third-largest but opaque fixed-income market. Investors need to improve their understanding of bond issuers and assemble a research team on the ground to dive deep into corporate financials, to compensate for the absence of full disclosure and international rating agency coverage.

The task ahead is daunting. Foreign investors are significantly underinvested in Chinese bonds. They own just over 2% of the onshore market and would need to launch an investment spree to match the index weight.

If China were included today in the most widely followed JP Morgan GBI-EM index for emerging markets debt, it could command a 10% weighting in the benchmark.

Last year, Bloomberg launched two parallel versions of its fixed-income indexes to include China bonds, while Citi did something similar with its World Government Bond Index (WGBI), including Chinese bonds in its sub-indexes.

The full inclusion of China’s bond market in global bond indexes could bring in as much as $286 billion in passive inflows, Standard Chartered said in a report last month. To be ready for the opportunity, fund managers need a far better understanding of the nation’s debt and credit markets, and the volatility associated with investing in China. Unfortunately, there isn’t any proper reckoner as yet.

For starters, a vast majority of the onshore issuers and bonds are not yet rated by any of the international rating agencies. For now, ratings of the ­onshore bond market are dominated by local firms which have been generous to bond issuers. More than four-fifths of the nearly 5,000 corporate bond issuers in the country have a rating of AA or higher, grades conferred only on the safest companies. Chinese rating agencies place a greater weight on implicit government support for state-owned enterprises, which are the biggest corporate issuers in China.

That assumption notwithstanding, corporate defaults have risen sixfold from a very low base two years ago as Beijing cuts capacity and moves to suck out excess liquidity.

Last year, following the launch of foreign onshore trading initiative Bond Connect – another of China’s moves to open up its markets – rating agencies such as Moody’s and Standard & Poor’s were given the green light to rate Chinese domestic issuers. However, when they can actually do so is unclear. The rating agencies need to be licensed to operate on the mainland. This is a contrast with Bond Connect, which allows foreign investors to access China’s onshore bond market through brokerages in Hong Kong.

The international rating agencies at the moment are only allowed to assess offshore bond deals, and their score on Chinese issuers clearly diverges from their local counterparts.

This all underlines the need for asset managers to invest in fully fledged analysis and hire people on the ground. One of the largest US fund managers, Fidelity International, has set up a China research team.

Fund managers also need to work out ways to combat the rising volatility. For instance, late last year following the Communist party congress, the implications of liquidity curbs rattled investors and led to the biggest bond sell-off in four years.

However, for money managers the effort, time and money comes with a bigger reward. It gives them access to the debt of a country that remains a net creditor and one that is unlikely to have any big inflation spikes. A surge in inflation typically eats away at bondholder returns.

Next, the nation’s bonds offer a yield premium, which is a big draw amid low returns globally. China’s 10-year bonds yielded 3.9% compared with 2.45% for their US peers.

As such, investors who can build a deep expertise of Chinese bonds will certainly have the opportunity not just to diversify their portfolio, but to add higher returns, as long as they can manage the risks adequately.