China’s onshore corporate bonds have had a bull run this year – very much the exception compared to weakness in local equities and the country’s generally gloomy economic backdrop. And while a surge in supply of Chinese sovereign bonds recently caused a brief jump in short-term borrowing costs, we think the run has further to go.
Returns on Chinese bonds have beaten many of their global peers this year as China eases monetary policy while most of the world tightens. Within China, the outperformance of onshore credit has been in sharp contrast to the sluggish sentiment in local equities, the downturn in the property market, and a weakening renminbi. And there are signs that China’s corporate bond rally could have further to run, despite trouble in the economy.
The central government’s debt swap program to help local government financing vehicles (LGFVs - the biggest class of corporate credit issuers in the onshore market), has revived demand for their bonds, even those issued by the most heavily-indebted regions.
In the secondary market, the municipality of Tianjin’s average credit spread - or yield premium over government bonds of a comparable maturity - has narrowed over 450 basis points since August 20231 to 66 basis points. A similar trend has been seen for Yunnan province LGFVs, where average credit spreads tightened by nearly 250 basis points in the same period to 297 basis points.
Even the cash-squeezed property sector has delivered some good news. State-owned Shenzhen Metro Group, the biggest shareholder of property developer China Vanke, pledged in November to provide help for the real estate giant, including taking over some of Vanke's urban renewal projects.
That news, plus the government’s continuing support measures for housing, have combined to provide a measure of relief to investors worried about the housing crisis spiralling out of control.
The rally has already pushed onshore credit spreads to their narrowest levels since November 2022, when signs of China’s exit from Covid lockdowns triggered a rapid rotation from bonds to equities. And although the recent fiscal easing and related rush in supply of government bonds caused a brief jump in short-term money rates in late October, over the medium term, higher-rated bonds are set to decline further as China’s bumpy economic recovery drives investors into safer assets and prompts the People’s Bank of China (PBoC) to further ease monetary policy.
Mind the speedbumps
The risks include infrastructure investment, which may not be able to provide as much of a boost to the economy as needed, due to a lack of funding for local governments whose land sales have dwindled. We recently visited LGFVs in several provinces. Instead of ramping up investments in roads, subways and other infrastructure projects, the LGFVs are preoccupied with managing liquidity risks and repaying debt.
Some finance managers said they had to burn the midnight oil to work on the refinancing plans. Central government has stepped in to ease local governments’ near-term liquidity pressure, but policymakers are still inclined to contain local governments’ borrowing over the medium term, which will limit their capacity to support growth.
Second, the property sector may stabilise, but demand will remain subdued. Until consumers regain confidence in their prospects for income growth, their willingness to borrow and buy new homes will stay depressed. Moreover, in the long run, a shrinking population and slowing urbanisation will also weigh on the housing sector.
Defaults decline
Deep structural problems like these could drag on the economy and lead to more easing measures from the PBoC. This loose monetary environment will continue to offer breathing room for corporate borrowers. In the first 10 months of 2023, only eight borrowers experienced first-time defaults in the onshore market, compared with 39 in the same period of the year before2.
But we would exercise caution further down the credit curve. First, lower-rated bonds’ yield advantage over similar-maturity government bonds isn’t high enough to justify the credit risk. Second, cheap credit is only a temporary fix. Without solid improvement in the underlying credit fundamentals, weak issuers will inevitably face renewed problems with their debt once policymakers eventually start pulling back on easy money.
There have been outflows this year by international investors as the 10-year US treasury yield premium widened over similar-maturity China government bonds (having touched the highest levels in over two decades in October, in fact), but we view these as tactical moves rather than a structural shift. And because foreign investor holdings only account for around 2 per cent of China’s onshore bonds, their effect on the broader market remains minimal.
The low correlations between onshore bonds and other asset classes continues to provide attractive diversifying benefits to global portfolios. In the long run, China’s efforts to internationalise the renminbi, along with measures to open up and further develop the domestic market for credit ratings and bond research, will help improve transparency and deepen price discovery in the market, ultimately supporting stronger demand for Chinese fixed income.
Sources:
1. According to data compiled by Fidelity International and Dealing Matrix
2. According to Fidelity International’s analysis of data compiled by Wind Information
