Risks vs rewards of investing in onshore Chinese bonds

May 6, 2021

The size of China’s bond market

China’s onshore bond market has doubled in the past five years. The fixed income market expanded by 18% to RMB114tn (USD17tn) in 2020; local governments (which issued 22% of total outstanding bonds), the central government (18%), and policy banks (16%) were the largest issuers.

Flows to China’s bond market

China’s bonds have recorded average net monthly inflow of a little over USD9bn over the past two years. FTSE Russell announced that it would include China government bonds in the World Government Bond Index over a period of three years. Their weightage would be 5.25%, translating into inflow of USD150-180bn.

Accessibility reforms, index inclusion and onshore opportunities attract global capital; however, foreign investors own only 2.5% of the market. Commercial banks are the main investors in local-government bonds, holding c.85% of total local-government bonds outstanding as of March 2021.

The case for investing in China government bonds

For global asset managers, China bonds are an attractive option, as they enhance returns (spread of ~300bps over aggregate G3 yields) while de-risking a portfolio (correlation of >0.2% with major developed-market global bonds).

Investor concerns on China’s onshore bonds

Given the value added to global portfolios, asset managers are likely to want a share of China’s bond market (the world’s second largest). However, there are risks:

  1. Recent defaults by state-backed issuers (which account for c.60% of the outstanding bonds) have caught investors off guard

  2. The low credibility of domestic rating agencies (<90% of the bonds are rated AA and above), as the recent defaults were by issuers rated AA and above

  3. Lower transparency, weak governance standards and international investors’ lack of expertise in the local language