Bond Connect: The challenges of investing onshore

The credibility of domestic credit ratings and a lack of hedging tools remain some of the challenges for China to develop a truly international bond market, FinanceAsia's inaugural bond connect survey reveals.

In FinanceAsia’inaugural Bond Connect survey, we asked investors about key issues surrounding the market and Bond Connect, the market access scheme established by the China Foreign Exchange Trade System (CFETS) and Hong Kong Exchanges and Clearing (HKEX).

This trading link, which mirrors an existing Stock Connect scheme, enables offshore investors to buy and sell the full gamut of bonds traded on China’s interbank market through Hong Kong.

It means that foreign investors do not need to set up an account on the Chinese mainland and can use their offshore banks to execute trades.

In the second part of the survey, we reveal our findings on some of the concerns facing bond investors when investing in the onshore bond market.

“INFLATED” CREDIT RATINGS

The lack of reliable and differentiated Chinese credit ratings is all-the-more conspicuous against a background of rising defaults.

Roughly 25 Chinese companies have defaulted on their onshore bonds so far this year as domestic credit conditions tighten. They include China CEF, a finance-to-energy conglomerate, and Fuguiniao, a Hong Kong-listed clothing company, according to data provider Wind.

Part of the confusion lies with the different ratings systems employed by domestic agencies such as Dagong, Chengxin and Lianhe and international ones like Moody’s Corporation, Fitch Ratings, and Standard & Poor’s.

Domestic agencies typically assign more generous ratings than their global counterparts. Wind data reveals that over 80% of China’s outstanding corporate bonds were rated AA or higher at the end of 2017.

There are also differences in the way that Chinese credit rating companies analyze risk. Some evaluate according to what assets companies own rather than their ability to repay creditors, which confuses many outsiders.

“Many international observers regard the onshore credit rating agencies [as] showing less differentiation and less granularity,” said Collins, the lead manager of the Fidelity Asian High Yield Fund. “Onshore and offshore agencies also favour different factors, such as size of assets by the former and lower leverage by the latter.”

The country’s guidelines for insurance companies and pension funds have not helped bring ratings in line with international norms either. For example, Chinese insurance companies can only buy a bond with an AA rating or above, which essentially pushes bond issuers to chase after higher ratings.

In order to address the problem, this March the National Association of Financial Market Institutional Investors, an industry body under the aegis of the Chinese central bank, said that it would accept registration applications from foreign rating agencies.

So far, S&P Global and Fitch Ratings have applied for licenses, while Moody’s has said it is reviewing its options. Few doubt that their involvement will bring more foreign capital to China thanks to their more systematic and discriminate ratings approach.

When it comes to the credibility of onshore ratings, Karan Talwar, a Hong Kong-based debt specialist at BNP Paribas Asset Management, said: “This is an issue in the onshore market and one of the key areas that will likely need to be addressed before onshore corporate bonds can enter global bond indices.”

An environment of rising defaults makes it far less likely that foreign investors will want to diversify into the unchartered waters of corporate credits. Indeed, 72% of FinanceAsia’s respondents say they are unlikely to change their investment mix over the next 12-months and those that did, say they are likely to buy more CGBs not fewer. Nearly half of all respondents (45.8%) also believe that investor protection is lower in China compared to the rest of Asia Pacific.

“Given the current state of the economy and China’s longer-term debt deleveraging initiatives, corporate default rates are likely to increase and indeed we have seen this in both the onshore and offshore market in recent periods,” Talwar commented.

LACK OF HEDGING TOOLS

China’s rising default risk makes effective hedging instruments all the more pressing too. This casts an unflattering light on the relative absence of tools such as interest-rate futures (IRS) and credit default swaps (CDS): common derivatives that foreign investors use to protect themselves from big market swings, or in the event of a corporate default.

To be sure, most foreign investors in China are largely long-only funds, meaning they usually adopt a buy-and-hold strategy until a bond matures.

But more is needed. While the size of China’s debt market has expanded nine-fold over the past decade, the lack of market-friendly instruments and restrictions on capital movements has – beneath the surface – strangled the rapid development the government would like.

“The next phase of development will concern interest rates and corporate derivatives,” Yim concluded.

But at the end of the day, acceptance will come with familiarity and that will require far more education, due diligence and investor protection. FinanceAsia’s survey demonstrates that this, above all else, is what investors want. 

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