China response to U.S. criticism points to rising sanctions risk

China's firm response to U.S. criticism at the Alaska summit between their top diplomats highlights strains building between the two nations.

This analysis is by Bloomberg Intelligence Credit Strategist Timothy Wee Lee Tan. It appeared first on the Bloomberg Terminal.

The domestic political situation in America may press the Biden administration to increase sanctions against China, creating short-term risks and longer-term opportunities for investors in China dollar bonds.

China could retaliate vs. more U.S. sanctions

Last month's difficult meeting between Chinese and U.S. diplomats in Anchorage may mark the next escalation in tensions between the two nations. New sanctions on Chinese officials before the summit set the tone for the discussions. We don't expect current economic and trade measures imposed by the U.S. to be removed. The chasm between interests on both sides looks set to limit any cooperation. We expect the summit's outcome to provide more impetus for the U.S. to impose more restrictions and for China to retaliate accordingly.

Steps the U.S. may take include wider export restrictions on technology, investment restrictions for U.S.-based capital, and expansion of financial sanctions against China state and non-state entities. China's response may include rare-earth embargoes and restrictions on inbound direct investment.

 

China investment-grade bonds may underperform

Geopolitical tensions between China and the U.S. continue to plague the overall performance of China investment-grade bonds. The option-adjusted spread for China IG has lagged Asia ex-Japan's spread since sanctions were imposed by the U.S. in 2020 under the Trump administration. Expectations that the Biden administration could be more conciliatory have now been dashed, and given the potential for more U.S. actions against China and potential retaliatory moves, we think China IG's OAS may widen further vs. Asia ex-Japan IG, at least until the bonds are redistributed back to Asian and Chinese holders. The potential lack of U.S. and European bulge brackets in the secondary market may add a liquidity premium to China IG bonds.

For non-U.S. investors, any short-term dislocation could present an entry level for China IG bonds.

China IG vs. Asia ex-Japan IG OAS spread

Source: Bloomberg Intelligence

China IG OAS dispersion shows sanction impact

Chinese sovereign-owned entities sanctioned by the U.S., which are generally strategic entities, trade wider than non-sanctioned sister companies and private corporations. China Nuclear Power Group trades wider than Alibaba and Tencent, private tech entities. Similarly China Three Gorges Corp, a key power-generation company, trades at a discount to the State Grid of China. Sanctioned companies in general trade wider though fundamentally, they generally have similar metrics to non-sanctioned SOEs and enjoy similar strategic status. Names that are currently not sanctioned risk joining those on the list as China-U.S. tensions continue to rise. From a credit-metrics perspective, one might view the sanctioned groups as offering better value.

And if geopolitical tensions lessen, sanctioned issuers may outperform.

Selected China corporate USD bond OAS curves

Source: Bloomberg Intelligence