China’s Influence on High-Yield Grows
Despite the year starting with turbulence in global equity markets, Asian high-yield has followed a similar path to 2015. Once again there is a division between struggling commodity-related issuers and everyone else, led by China’s property developers, who are continuing to outperform.
Developer bonds are being supported by favorable policy towards real estate by Chinese authorities, as well as various technical tail winds.
One change that appears to be getting more pronounced this year is the Chinese influence on liquidity in high-yield. This started last year when Chinese regulators re-opened the domestic bond market in June. As Chinese issuers subsequently switched to funding onshore, this had a knock-on effect on offshore markets where reduced supply created a scarcity premium.
Further, adding to this is a trend of retiring offshore debt. To the extent Chinese companies have cash on balance sheet and onshore financing readily available, they are incentivized to repay offshore debt early.
So far this year, this trend has accelerated. As of 19th February, corporate bonds issuance in China had already reached 173.4 billion yuan ($26.4 billion), up more than seven-fold from a year earlier reported Dealogic (see the chart below as well). At the same time there have been no offshore CNH bonds from Chinese issuers since November last year and offshore USD China high yield bond issuances have been a paltry $735m for 2016 compared to $3.4 billion for January and February 2015 (down ~78% year-on-year).
The other side of this onshore bond issuance spree is a surge in demand from local investors and institutions. Thanks to renewed falls in China’s equity markets this year, investors have been eager to seek shelter in high-yield bonds, as their defensive qualities come to the fore. In comparison to equities, the volatility in onshore bond issuances is significantly less.
We also suspect some of this new Chinese appetite for high-yield investing has spilled over into offshore markets. While Chinese corporates are getting cheaper funding domestically, the corollary of this is their investors are getting paid less yield.
Offshore bond yields are about 3% higher than those onshore and also being denominated in foreign currency gives Chinese investors protection against further potential declines in the yuan.
Here we can see how China is responsible for both a tighter supply of bonds offshore, as well as adding a new source of liquidity onshore. But Chinese influence does not stop here.
Another characteristic of mainland Chinese bond investors is a tendency to buy and hold. This is most likely a natural behavior carried over from its domestic corporate bond market, where there is still effectively no secondary trading. This situation has been able to persist given the market is still relatively new with limited foreign participation. There have also been negligible default rates with an assumption of implicit state backing.
If Chinese liquidity were indeed spreading to the wider Asian offshore high yield market, this would help explain its outperformance vis-a-vis other high-yield markets this year. It might also offer an explanation for the fact prices have firmed as liquidity has decreased.
Meanwhile, although we are seeing investor interest in existing bonds, the market for new bonds remains extremely subdued outside higher-grade issuers. This again has added to a shortage of investable paper in the market.
This scenario means we may now have to add another linkage between China and high-yield. Not only does mainland property account for over half of all issuances and its industrial demand remains critical for the region’s hard commodity issuers, but it could now also be a key factor in trading liquidity.
How much is hard to say given the difficulty in attaining accurate trading data, yet in recent quarters there has been a notable pick-up in capital flows exiting China, which continued in January.
One question is how far can technical factors outweigh fundamentals?
There was a reminder last week after S&P warned that corporate repayment risks are rising in Asia. The latest results from HSBC and Standard Chartered also suggest there is more pain about as both included notable increases in provisioning for problem loans, with commodities highlighted.
The next consideration is how much value is there in Asian-high yield if technical and liquidity factors are so important.
It can be argued that in general Asian bonds look expensive given the level of risk at play and yield generation, especially when viewed on a relative value basis versus US or European markets. Part of this is due to the steep sell-off in US and European high-yield bonds, which have heavy weighting in energy and oil.
In contrast to Asia where fund inflows have helped, the US and Europe have suffered large fund closures and redemptions. This has seen some foreign funds redirect their efforts to their home markets. However, Asian markets have continued to be bolstered by an increased amount of local buyers.
The difficult question is how long these relatively benign conditions in Asia can remain. Much depends on Chinese government policy and the resilience of its financial sector to unexpected shocks. If fundamental risks do rise and yet are not reflected in price levels due to market technicals, this could in itself be enough to lead to negative price adjustments. Furthermore, Asian high-yield could be vulnerable to a sudden reverse in Chinese liquidity resulting in prices adjusting downwards to reflect the true level of fundamental market risk. Asian high yield continues to outperform, however the astute investor needs to be keenly aware of the pitfalls outlined above to accurately manage risk.
Jamie Tadelis is Co-Founder and Head of Sales at SC Lowy, an independent fixed income specialist based in Hong Kong.