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Supersized value pocket

China’s onshore bond market is the third largest in the world, behind only the US and Japan. Having been tantalisingly difficult for international buyers to trade historically, new access routes create a supersized value opportunity. Index diversification and a quality primary issuance pool await investors seeking alpha off the beaten track.

We have seen emerging markets (EM) establish themselves as prosperous hunting grounds for investors looking to go off the beaten track in search of growth and value.

As globalisation increases, investors must continually think ahead in an effort to find rewarding opportunities. Among the most successful have been those able to identify pockets of value in EM in order to generate alpha – outperforming the base return of the relevant benchmark index.

We foresee the latest ‘pocket’ of EM value for fixed income investors in the form of a 9.5 million square kilometre landmass with a population of 1.4 billion and an economy worth USD 10 trillion: China has greatly improved the accessibility of its onshore bond market to international investors and we believe the alpha generation potential is vast for those who can gain access.

While China has been an EM investment hub for years, made famous to equity investors by Jim O’Neill’s ‘BRICS’ acronym, for those in the fixed income markets, access has largely been via the relatively small offshore market (approximately USD 123 billion across some 200 issuers).

In looming contrast, the onshore market – officially known as the China Interbank Bond Market (CIBM) – is the third-biggest bond market in the world, behind only the US and Japan.

What makes the opening of the onshore market so appealing to us is the potential for active investors to build their exposure to Chinese debt through issues not commonly held or featuring in global benchmarks. We believe this deviation away from the main indices is the key to return generation. When onshore issuers deliver, the return is pure alpha.

For those who can crack the language barrier, the brokerage relationship with local banks may prove as valuable as holding the securities themselves. On-the-ground research is a key component of rigorous active management, with a direct line of communication to analysts and brokers at local banks broadening and strengthening market understanding.

As a license holder, we can offer our clients exposure to what in our view is an untapped opportunity set. We are actively looking for attractive potential onshore opportunities as allocation alternatives to offshore exposures.

Primary issuance – new debt – uptake by international buyers has been modest in the offshore market, primarily due to geographic constraints. While available to all, marketing efforts by issuing companies typically target Hong-Kong and Singapore, meaning those in the West tend to come across issues closer to their release dates, leaving little time to conduct thorough credit research. While timing constraints remain the same for the onshore market, the pool of new issues increases greatly.

Many high-quality issuers have never needed to venture across to the dim sum market as they can comfortably raise funds through the domestic buyer-base, meaning the offshore primary issuance market contains more high yield and fringe names. Those investors who gain onshore access can expect both a bigger and higher-quality issuance pool.

Real estate is a sector that we find particularly appealing via onshore primary issue. China’s property market – historically banned from issuing onshore debt – has been subject to bubble scares and bad press, but we see value in the unloved sector and the fundamentals look healthy, making it appealing at the right price.

With all this upside there must always be downside, and for onshore Chinese debt, ratings, defaults and volatility have proven the three big challenges facing trailblazing investors.

The market has to-date been solely rated by Chinese agencies, leading to generous results with half of all outstanding corporate bonds having AAA ratings at the end of 2016, according to Wind Info. But pressure by the Trump administration has led to the promise of US ratings agencies being allowed to grade the market. In a related move, the Chinese government is now allowing onshore companies to default.

The opening of the market marks a pivotal step forward in China’s positioning in the global fixed income universe, while strengthening the global prominence of EM. The value potential is plain to see, while the access challenges are proving themselves an exclusivity silver lining for those ahead of the curve and early to the opportunity set. In the case of onshore bonds, we believe the early bird will catch the juiciest worm, and we are excited to take our investors off the beaten track in the name of alpha trailblazing.

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Market Insight

Brent David

Brent David
Senior Portfolio Manager Emerging Markets
Published 14 February 2018
Download article here.
5 minute read

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Published February 2018