What Makes China’s Corporate Bond Market Different?
China’s bond issuance has continued to expand rapidly since it became the second-largest market in the world in 2013.
Bonds outstanding (including government and corporate bonds) reached RMB48 trillion (about US$7.2 trillion) at the close of 2015, a 30% increase over 2014. Meanwhile, thanks to RMB internationalization, more foreign investors have entered the market.
This is why the 10th Asian Bond Markets Summit was held in Beijing for the first time. I attended this forum and exchanged views with a range of participants, from domestic and international investors to ratings agency representatives. Two things are worth highlighting:
First, all agreed that there is still considerable room for China’s bond market to develop. China’s outstanding bonds account for about 70% of GDP, much lower than the 200% in the United States. And the share held by foreign investors is around 2%, significantly less than 9.2% in Japan and the 13% average in emerging markets.
Second and more importantly, there are some distinguishing features of Chinese corporate bonds, of which credit rating and default risk are the most confusing. To clarify these questions, it is useful for foreign investors to understand how China’s bond market operates.
Credit ratings in China do not sufficiently reflect information about credit quality. This is due to lack of differentiation: More than 90% of Chinese corporate bonds are rated AA or above. Moreover, the high ratings are not recognized in overseas markets. For example, the bonds issued by Sinopec and State Grid are rated AAA in the onshore market, but they are rated A+ in the offshore market. The key to understanding this development is that policy matters more during the rating process in China than in other markets, according to Wang Ying, senior director of Fitch Ratings.
Fitch summarized its rating process as a combination of bottom-to-top and top-to-bottom. Bottom-to-top means evaluating an enterprise’s financial strength the same way the process is done in developed markets. Top-to-bottom, on the other hand, means taking policy into consideration. This is especially important for the state-owned enterprises (SOEs) whose performance is heavily affected by government policy.
In 2011, when coal prices were high, power producers experienced losses. Despite that, Fitch still assigned a high rating to their bonds, only slightly lower than that of government bonds. Wang explained that the profit decline resulted because electricity prices were strictly controlled by the government, so that the producer could not transfer the high cost to the end user. Furthermore, power investment was supported by the government at that time, implying the enterprise could get bank loans at a low interest rate.
High credit rating is also affected by the regulation rule, said Li Zhenyu, vice president and chief research officer at China Lianhe Credit Rating Company. If a bond rating falls below AA, raising a risk alarm is required. This makes it difficult for an enterprise to issue its bond successfully.
Identifying default risk is also confusing. In 2014, when the first default emerged, the market expected to have more of a role in the energy sector. So far, the signals are mixed. More corporate bonds defaulted as the economy slowed, and the issuers included both private and state-owned enterprises. In some cases, the government stepped in. In other cases, it didn’t.
Wang admitted that the government, especially local government, treats SOEs differently. Some SOEs have a closer relationship with local government than others. Local government is inclined to bail out those enterprises that it deems important, such as those that contribute more employment and tax revenue.
Another interesting point was made by Leon Huang, head of fixed income at SinoPac Securities in Taiwan. According to Huang, private enterprises are likely to deal with the default problem more actively because they care more about their reputation in the market. By comparison, SOEs, which easily obtain loans from banks, don’t need to worry as much.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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