Midyear Outlook: China USD bonds

The continuing surge in the U.S. Treasury yield may have set the tone for a challenging 2H for the Asia ex-Japan high grades, but a positive catalyst remains as the Southbound Bond Connect is expected to begin in months, which could drive capital inflow due to huge spread differentials.

This analysis is by Bloomberg Intelligence Senior Credit Strategist Timothy Wee Lee Tan and Rates & FX Strategist Jason Lee. It appeared first on the Bloomberg Terminal.

High-yield returns are expected to bounce, based on historical patterns.

China Dollar IG Index ends 1H21 in negative territory

The Bloomberg Barclays China USD Credit Index ended 1H with a total return of -0.65%, driven predominantly by the rise in Treasury benchmark yields during the period. Excess returns was a positive 0.87%, despite the volatility created by Huarong. Treasury yield volatility is likely to remain high in 2H given inflation uncertainties. Bloomberg's forecast for the 10-year yield at end-2021 is 2.19%, which may indicate that total returns for the China IG index is unlikely to recover into positive territory. Positioning in portfolios may need to take into account the shape of the curve as well. The market is heading into 2H with a significantly flatter curve, and we may see continued flattening initially, before steepening back out. Hedging agility is key to capturing more alpha.

 

China USD IG -YTD total return & OAS

China USD HY Index struggles with contagion-linked volatility

Contagion from Evergrande hammered the Bloomberg Barclays USD China HY Index in June, reversing the gains for the year to date with a loss of 1.71%. Similar drawdowns have historically been followed by sizeable bounces. As near-term default risk for Evergrande is low, we may see a rally in July and August, which could return the index to positive territory for 2021. The Three Red Lines policy will continue to create winners and losers in the real estate sector. That said, most real estate firms will be able to successfully reduce their financial leverage amid stable property markets, as demonstrated by Evergrande's quick sale of a development project. We view this as a positive credit driver for the index and expect overall credit ratings in the sector to rise in the next 12 months, which will further support performance.

6-Year average return of China USD HY

 

Investment grade kungfu bonds OAS may tighten 30-80 Bps

The current option adjusted spread differential between domestic China issuance and offshore bonds of investment grade corporate issuers range from 40 bps to more than 150 bps. This spread differential is likely to narrow as China opens the capital floodgates for domestic investors to invest in these securities. While it is unlikely to completely eliminate the differential due to hedging costs, we should still see significant tightening in the China IG offshore space.

Issuers that have the widest differentials should benefit more in 2H as the Southbound Bond Connect takes off. Given there isn't likely to be any quotas, the capital flow into the market will be capped by the actual economic incentives and pace will be determined by how fast the logistical bottlenecks are cleared.

OAS differentials between CNY & USD bonds

 

Positive impetus for China investment grade from Southbound

China's Southbound Bond Connect will drive capital into the Chinese dollar bond market in 2H, given the relatively wide spread differential between on-shore and offshore markets. The rollout pace will depend on the speed at which accounts are set up between on-shore investors and offshore market players. The full rollout is expected to complete in 6-12 months. The universe of investible bonds is about $1 trillion with mainland China, Hong Kong and Macau risk making up about 93% of the total amount outstanding. There will be no quotas, unlike the QDII program.

Investment grade kungfu bonds should tighten more than high yields due to the wide spread differential between on-shore and offshore issuance.

Investible universe by Bloomberg Composite Ratings

 

Volatility from Local Government Operating Entity defaults

We expect more credit default events from local government operating entities (LGOEs) in China due to the push by the central government to rid the system of unviable local government firms. The fallout may negatively impact China's offshore bond market on short-term contagion, especially when there's currently little differentiation between different types of state-owned enterprises. While most of the offshore issuance by local government entities are Chengtou, and should have low default rates, on-shore defaults from LGOEs of a province are likely to impact the spreads of dollar Chengtou from the province. An example of this contagion is Henan Energy & Chemical Industry and Yongcheng Coal -- LGOEs from the province -- which impacted Henan offshore Chengtou spreads.

This may be repeated as local LGOEs default rates rise.

Henan Chengtou historical OAS

 

U.S. sanctions continue to be wildcard for kungfu bonds

China credit dollar bonds may be buffeted by the ongoing use of sanctions by the U.S. to suppress China's technology sector and the Belt and Road Initiative. The rising geopolitical tension between China and the U.S will continue to affect those who can invest in China dollar bonds. The impact will be more about short-term liquidation risk from sanctions rather than any actual fundamental credit impact. Issuers previously not in the sanction list but pose a threat to U.S. interests may be put on the Biden administration's blacklist.

While we expect the credit conditions in the current list to be less impacted, it must be noted that sanctions can expand to include not just an investment ban but also an outright transaction ban. This would be the next step that the U.S. may take if current sanctions aren't efficacious. See changes in sanction list.

Changes in Sanction List (As of June 3, 2021)