The Chinese economy is a juggernaut; its bond market is a burgeoning superpower. As of the end of 2020, the Chinese bond market was the world's second-largest. The total value of Chinese bonds stood at nearly $19 trillion (£14 trillion), representing 15% of the global bond market. Today, Chinese bond yields are materially higher relative to the United States, United Kingdom, and Eurozone. And Chinese bond prices are not highly correlated with either US Treasuries or the US stock market. At face value, this would appear to make them a decent diversifier. But an allocation to Chinese bonds isn't a free lunch. Despite its size, this market is still in its infancy, and there are many complications and nuances investors must consider. Nonetheless, exposure to the Chinese bond market has the potential to complement a core holding.
China's Bond Market in Detail
The Chinese bond market consists of three submarkets, defined by where bonds are issued and their currency denomination. The largest is the Chinese onshore local currency bond market. These are bonds issued in mainland China and denominated in renminbi. Totalling $17.5 trillion, this is easily the largest of the three submarkets. Most Chinese government and policy bank bonds are issued in mainland China in renminbi. These bonds' relatively high yields and low credit risk make this submarket the most attractive. The second-largest submarket is the Chinese onshore hard currency bond market. These are bonds issued by China or Chinese entities in mainland China in developed markets currencies, usually US dollars. Corporate bonds account for the largest slice of this pie. The third submarket is the Chinese offshore local currency bond market. These are bonds issued outside of mainland China (primarily Hong Kong) and denominated in renminbi.
Within these three submarkets, there are generally three categories of issuers: governments, policy banks, and corporates. Government bonds include Treasury bonds issued by China's Ministry of Finance and bonds issued by local government entities (akin to municipal bonds in the US). According to Bloomberg data, local government bonds were the largest issuer class in China, accounting for nearly 23% of the total onshore local-currency market, as of the first quarter of 2021. The local government debt market was tiny before 2015 and has mushroomed since, as the Chinese government allowed local governments' financing vehicles to swap their debt for government and muni bonds to boost local governments' credit profiles and reduce their borrowing costs.
Policy Banks
The Chinese Treasury bond market is actually smaller than the local government bond market, accounting for just 18% of the onshore local-currency market as of 2021. Policy bank bonds are sometimes categorised under the umbrella of government bonds but they have been separated from government bonds by major index providers. The State Council of China created three policy banks to foster economic growth: the China Development Bank, the Export-Import Bank of China, and the Agricultural Development Bank of China. These bonds are considered risk-free assets because they are explicitly backed by the Chinese government.
But policy bank bonds typically provide slightly higher yields than Chinese Treasury bonds as their tax treatment is less favourable for domestic Chinese investors. The size of the policy bank bond market is roughly the same as the Chinese Treasury bond market, but policy bank bonds are more liquid. The Chinese corporate bond market is diverse and fragmented. It is dominated by state-owned enterprises, as companies without explicit government support were largely prohibited from issuing bonds until 2007. State-owned enterprises still account for most of the market today.
Approximately 97% of Chinese local currency corporate bonds are rated AA or higher; this can make it hard to gauge the credit risk of Chinese companies fromtheir credit ratings, as the local scale they are rated on lacks meaningful depth. While many Chinese firms have received below investment grade credit ratings, they are exclusively hard currency bonds. Historically, foreign investors' access to the Chinese bond market was restricted to the hard currency and offshore local currency markets. Two recent events opened the local currency market, enabling international participation in the Chinese Treasury and policy bank markets. The inception of Bond Connect in 2017 streamlined market access for non-Chinese investors, while the inclusion of Chinese local-currency government bonds in major bond indices invited greater participation.
Understanding the Risks
Chinese bonds offer higher yields than similar bonds from developed markets issuers, but the extra yield is compensation for risk. Notably, the Chinese bond market is much less liquid than the US investment-grade bond market, so information is incorporated into prices less quickly and less reliably. For example, the International Monetary Fund noted that, as of 2017, Chinese banks owned 70% of all Chinese Treasury bonds and tended to hold themuntil maturity. Gleaning useful information from the market is also difficult for corporate bonds given the lack of granularity that characterises the onshore market's credit rating scale, as nearly all Chinese corporate bonds receive AAA or AA ratings from Chinese credit rating agencies.
"Pure play" exposure to the Chinese bond market is a risky proposition, because the poor performance of one corporate issuer could have a material impact on performance. And non pure-play exposure to Chinese debt also entails risk. For instance, local currency emerging markets bond funds tend to offer exposure to at least a dozen other currencies, and the issuers represented often lack the attributes that make Chinese debt appealing (such as growth and stability).
