Q&A: China's onshore bond market too expensive

BOCHK Asset Management remains confident about prospects for the offshore dim sum market once the currency stabilises.
Ben Yuen
Ben Yuen

Towards the end of February, the Chinese government took a major step towards the liberalisation of its capital markets by opening up its domestic bond market to international investors and scrapping the quota system. 

Details have yet to be worked out but the step marks a coming of age for China's domestic bond market, now the world's third largest with almost $6 trillion of outstandings.

But how will that affect the once thriving offshore bond market known as the dim sum bond market?

Over the past month, FinanceAsia has been running a series of interviews with some of the region's leading fixed-income investors.

Here, Ben Yuen, head of fixed-income at BOCHK Asset Management in Hong Kong, discusses why the dim sum market will continue to be an attractive investment vehicle for funds with offshore Rmb. 

Yuen also explains why the bond rally still has legs even though the Fed may start raising rates again later this year. 

At the end of 2015, BOCHK Asset Management had $8.1 billion of assets under management in fixed income. 

After the Fed started raising rates in December, many expected 2016 to be a bad year for the bond markets. Do you think this will still be the case?

Ben Yuen: Bonds have outperformed equities ever since central banks embarked on quantitative easing in 2008. At the end of last year, when the Fed made its first move, economists thought 10-year Treasuries would rise to around 2.7% by the end of 2016. 

But right now they’re trading around the 1.82% level. There’s a new consensus forming towards a peak in low 2% level area. That low interest rate environment combined with the uncertain global growth outlook will be good for bonds.

Deflation is the main concern. Chinese exports are down year-on-year.

That’s not because China has become less competitive as the Rmb appreciated over the past decade. It’s because global demand has not been there. Now we have a situation where China is slowing, the emerging markets are slowing and potentially even the US is slowing.

Overriding all that, the financial markets have long been concerned about a contraction in the money base once the Fed started raising rates. There’s been a big increase in the money base since 2008, but a lot of it has gone into asset prices rather than the real economy.

How do you think that will impact the shape of the Treasury curve?

We expect it to flatten further. A few months ago there was 140bp on the curve between two- and 10-year Treasuries. Now it’s more like 90bp.

I don’t think the curve will invert though because the market is not pricing in a recession but flat growth. If the US did follow Europe’s lead with negative interest rates then the long end of the curve would obviously shift down more, but I don’t think that will happen either.

I still think we’ll see a rate rise this year. Economists are forecasting less than a 20% chance of it happening in March and I agree with that. But I do think we’ll see action by the end of the year.

The market is pricing in a lot of downside risk. But I think China will achieve fairly stable economic growth in 2016. The government still has a lot of leeway to apply fiscal stimulus and achieve 6.5% growth.  For example, we think there’ll be a cut in the Reserve Requirement Ratio and in the lending rate.

When do you think that will happen?

Probably in the second half but, if the Rmb is stable, it could happen in the second quarter or earlier.

Once this volatile period passes, I think we’ll see more stable data points coming out of both China and the US. Then the Fed will start to be more pro-active about tightening.

How will that impact overall returns?

Investment grade spreads have outperformed high yield by quite a substantial margin. Yes, both have widened relative to US Treasury yields, but investment grade by less of a margin because of the base effect.

If my base case scenario is correct, then once the global economy stabilizes and Treasury yields rise, credit spreads will tighten as well. This will support total returns and both investment grade and high yield will still deliver positive returns over the course of 2016.

Which sectors do you favour at the moment?

We’re overweight in Chinese property.


There are a few reasons. Firstly, as I mentioned before, we’re confident about Chinese GDP growth, plus the government has pushed out a number of measures to support the sector. Secondly, the People’s Bank of China is in an easing cycle and this will underpin the sector too.

Thirdly, there’s strong demand for property in first-tier cities where supply is quite limited. And even in third-tier cities, where there was a lot of overcapacity, it’s on an improving trend as well.

Any other sectors?

We also like the consumer sector. The services sector is now more than 50% of Chinese GDP.

Yes but hardly any consumer companies have issued offshore.

That’s true but it will be far easier for investment banks to bring these companies to the international bond markets compared to companies from traditional industries suffering overcapacity such as mining.

It will be a good way for Chinese consumer companies to diversify their funding base. I think international fund managers will be particularly keen on non-investment grade issuers in this sector because of the higher yield.

From the issuer’s perspective they’ll be able to raise higher volumes offshore than they can onshore.

Do you invest in the onshore market?

We haven’t applied yet. We find the onshore market too expensive right now. Interest rates are lower in China and spreads are very tight.

There’s also Rmb volatility to consider as well. We might apply when the Rmb stabilizes but there’ll always be a large pool of offshore Rmb assets to invest in.

At the moment, we have a mix of 5% dim sum bonds, 90% US dollar-denominated bonds and 5% in cash. Last year, the ratio was 70%/30% in favour of US dollar-denominated bonds. 

There has been little issuance in dim sum bonds recently but that won't last forever. Over the medium- to long-term, the offshore Rmb capital pool is likely to increase by about $100 billion to $200 billion per year, which will support the demand for dim sum bonds.

Once China’s capital account opens up, the onshore and offshore market will become one anyway.

How worried are you about declining issuance by Chinese property companies now they’ve all headed onshore?

Yes supply has come right down.

In the past, Chinese property companies were happy to issue offshore because the Rmb was appreciating. But it’s now much cheaper for them to issue onshore where interest rates are lower and there are now less issuance restrictions.

We calculate there’s roughly $55 billion in outstanding Chinese property bonds. We think about 10% will disappear this year. About $4.5 billion of debt will mature and a further $1.4 billion could get called away.

So there is a very strong technical factor underpinning spreads from this sector.

What’s your view on Chinese bank capital paper?

We find AT1 (Additional Tier 1) paper a bit expensive at the moment. Spreads are tight because it’s been very popular with Chinese private banking clients. But we prefer Lower Tier 2.

A potentially interesting new source of funding will come from Asset Backed Securities (ABS). The market is expecting the Chinese government to allow domestic banks to issue up to Rmb50 billion of ABS based on their non-performing loans to clean up their balance sheets. 

It will be interesting to see where the demand comes from. I suspect they’ll be popular with WMP (Wealth Management Product) funds, which are looking for higher yielding assets now they’re only getting 5% from AT 1 paper.

The overleveraged Local Government Funding Vehicles (LGFVs) have been a long-standing concern. How successful do you think the government has been dealing with this problem?

International investors have showed plenty of concern over the past five years, exacerbated by the lack of transparency surrounding LGFVs' overall leverage.

But I think there have been a lot of positive moves. The most important has been allowing provincial governments to issue debt and this buys the whole sector the time it needs.

The big concern was short-term debt allied to long-term projects, which won’t generate cash flow for years, if at all. But if you think back, the Asian Financial Crisis didn’t happen because projects couldn’t generate the cash flow in time to pay their debt.

1997 was the result of a currency mismatch combined with a lack of liquidity. In China’s case there is no currency risk and the provincial governments are now re-financing this debt and stretching out the maturities.

But that’s not going to be great for GDP growth if the provincial governments are raising money to forestall one problem rather than fund new growth.

There is some truth to that, but the government can do plenty of other things such as cut taxes and feed infrastructure spending through the policy banks. So I remain positive.  


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