Author: China Merchants Bank Research Institute Beijing Branch (Investment Banking Department)
■ Current status of the Chinese dollar bond market. The issuance of Chinese dollar bonds is mainly concentrated in the Hong Kong Federation of Trade Unions. In terms of rating distribution, rating is mainly based on -free bonds; since is more stringent than domestic rating agencies, the same entity may be given a lower rating overseas, increasing the issuer's financing costs. In addition, the Hong Kong Federation of Trade Unions does not have a mandatory rating requirement for listed bonds, so most Chinese dollar bonds do not have a credit rating. In terms of industry distribution, financial dollar bonds, real estate dollar bonds and municipal dollar bonds are the main issuance directions. Investment-grade Chinese dollar bonds are finance and municipal dollar bonds as the main industries, and high-yield Chinese dollar bonds are mainly real estate, accounting for 60%. In terms of trading methods, Chinese dollar bonds are mainly traded by over-the-counter market makers, and market makers provide active quotations. Moreover, Chinese dollar bond market participants are diverse, investment strategies are very different, and the overall market liquidity is good and trading is active.
■ US bond market outlook. investment-grade dollar bonds are mainly affected by the benchmark interest rate , mainly due to the benchmark interest rate plus liquidity premium; the trend of high-yield bonds is dominated by Chinese dollar real estate bonds, and the difference in the issuer's credit risk determines its credit risk premium. Since 2021, the U.S. bond interest rates have risen sharply with the expectation of interest rate hikes. The yield on maturity of investment-grade dollar bonds has also increased significantly, leading to widening of credit spreads. The risk of falling investment-grade bond prices has been released, and the overall margin of protection has increased; but the credit spread of high-yield bonds is still adjusting, and the bottom of price decline is still difficult to determine. Looking ahead, US inflation has basically peaked, but its stickiness is still high; the firm employment data provides room for interest rate hikes; it is expected that the Federal Reserve will maintain a tough interest rate hike policy to push up the unemployment rate and hit inflation to 2%. The probability of the policy benchmark interest rate rising to 4.25-4.5% or above has increased, and the interest rate hike cycle enters the second half. The short-term market pricing for currency tightening expectations has not ended, but it has come to an end. It is expected that the 10Y interest rate of US Treasury bonds will continue to rise, but there may be little room, with a high of 3.8-4%. The risk of the US economic recession is getting closer. With the arrival of US inflation trend and weakening of employment, the 10Y interest rate of US bonds will decline, the interest rate spread is expected to narrow, and the price of US bonds is expected to rebound. With the high benchmark interest rate level, the yield on Chinese dollar bonds will also maintain a high range. The allocation value of investment-grade dollar bonds with a high degree of yield trend and benchmark interest rates is gradually emerging, and it is currently a window period for the left to allocate/add to Chinese dollar bonds.
■ Investment opportunities and risk factors. Chinese dollar bond yield level is at a relatively high level, and it has coupon advantage over Chinese bonds. In terms of risk, from the perspective of default situation, the default risk is concentrated in real estate companies, and the industry risks are still rising. The RMB is still under pressure to depreciate, and the forward swaps of the US dollar against offshore RMB are negative, increasing the cost of locking the exchange rate. In terms of investment direction, municipal bonds and financial bonds are the main ones, avoiding high-yield real estate bonds. The allocation strategy is mainly based on the coupon strategy of holding investment-grade US dollar bonds to maturity; the market interest rate may gradually fall from a high level in the medium term, and part of the capital gains may be obtained under the premise that the credit default risk is controllable.
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Current market status of Chinese dollar bonds
(I) Issuance status: concentrated in Hong Kong Federation of Trade Unions, finance, real estate and urban investment are the main issuance entities
Chinese dollar bonds are bonds denominated in US dollars in overseas markets by domestic enterprises. They are a type of US dollar assets and are the main component of Chinese overseas bonds.
At present, the issuance of Chinese dollar bonds is mainly concentrated in exchanges in Hong Kong, Macao, Singapore , Europe and other regions. As of the end of August 2022, Chinese dollar bonds issued in Hong Kong accounted for about 60%, dominating. Singapore Stock Exchange also undertakes the issuance and trading of most of the remaining Chinese dollar bonds. Among them, real estate dollar bonds and municipal investment dollar bonds are relatively concentrated in trading on the Hong Kong Stock Exchange.
Figure 1: The proportion of the issuance market size of Chinese dollar bonds
Source: Wind, China Merchants Bank Research Institute
Figure 2: Rating distribution of Chinese dollar bonds
Source: Wind, China Merchants Bank Research Institute. According to the rating distribution of
, the debt-free rating is mainly based on the rating. Since overseas rating agencies are stricter than domestic rating agencies, domestic high-rated companies are usually given lower ratings by overseas rating agencies, which will increase their financing costs. In addition, Hong Kong Federation of Trade Unions does not have mandatory rating requirements for listed bonds, most (about 80%) of Chinese dollar bonds do not have credit ratings. Investment grade accounts for about 15%, and high-yield grade accounts for about 7%.
Industry distribution, financial dollar bonds, real estate dollar bonds and municipal investment dollar bonds are the main issuance directions. Investment-grade Chinese dollar bonds are mainly finance and municipal investment industries. The highest proportion of existing bonds is banking and oil and gas exploration, which is 23% and 14% respectively; these two industries are mainly state-owned enterprises or state-owned assets, and have high capital needs for overseas business expansion. The third place is the financial service industry, mainly AMCh, local financing platforms, etc., and is also the main body that has been more active in issuing bonds overseas in recent years. Among high-yield Chinese dollar bonds, real estate is mainly based on the market, accounting for about 60%. The distribution of other industries is relatively scattered, with the second and third proportions being banks mainly engaged in urban commercial activities, and financial services for some special backgrounds without rating issuing entities. Among the unrated Chinese dollar bonds, existing bonds are concentrated in the real estate, banking and financial services industries.
Figure 3: High-yield Chinese dollar bond industry distribution
Source: Bloomberg, China Merchants Bank Research Institute. BBB- and below are high-yield grades, while BBB- and above are investment grades.
Figure 4: Investment-grade Chinese dollar bond industry distribution
Source: Bloomberg, China Merchants Bank Research Institute. BBB- and below are high-yield grades, while BBB- and above are investment grades.
Figure 5: No rating Chinese dollar bond industry distribution
Source: Bloomberg, China Merchants Bank Research Institute.
(II) Trading situation: The liquidity of Chinese dollar bonds is better than that of domestic credit bonds
From the perspective of the relatively mature over-the-counter market maker system, diverse participants and large differences in investment strategies, the liquidity of Chinese dollar bonds is better than that of domestic credit bonds.
OTC trading is the main trading method of Chinese dollar bonds, and the market maker mechanism provides sufficient liquidity for the market. Investors conduct bilateral negotiations with market makers through electronic trading platforms (such as Bloomberg, Tradeweb, etc.). Market makers are investors' direct counterparts, custody and clearing in Euro Clear (Euro Clear). Market makers provide active quotations, and while achieving certain profits through bid and offer spreads, they increase market immediacy and liquidity. Domestic bond transactions are mainly in the interbank market, and the participating entities are mainly banks. The liquidity provided by market makers is not as good as that provided by overseas markets. In the environment where the scale of my country's bond market is large, the activity of credit bond transactions in the interbank bond market is relatively low.
The types of overseas investors are global and diversified, and trading demand and investment strategies are not easy to converge, which also improves market liquidity. Domestic credit bond investors are mainly domestic banking institutions with relatively high homogeneity. Investment decisions are convergent, which are prone to form a unilateral market and relatively weak liquidity. The investor structure of overseas Chinese dollar bond market is more diverse, including foreign financial institutions, Chinese financial institutions that establish offshore subsidiaries, domestic financial institutions that enjoy direct overseas channels, and professional individual investors. The investment needs of different market participants vary. Trading tools such as short selling and interest rate spread trading in overseas markets have also strengthened the market's two-way liquidity, activated the market participation heat, and the market liquidity is relatively high.
According to Bloomberg data, the daily trading volume of Chinese dollar bonds in on the offshore market usually fluctuates between US$1 billion and US$2 billion. Under normal circumstances, the monthly trading volume of Chinese dollar bonds is around US$30-60 billion, and the market transactions are active. From March to July 2022, the total trading volume of Chinese issuers in the offshore market was US$15.4 billion, US$6.8 billion, US$6.9 billion, US$10.4 billion and US$6.8 billion, respectively, and 8,273 transactions, 4,495 transactions, 4,340 transactions, 6,885 transactions, and 5,527 transactions were reached.
US bond market outlook: tightening expectations of trading will enter the second half of the year, and the benchmark interest rate will gradually top
(I) Factors influencing Chinese dollar bonds: benchmark interest rate and credit spread
investment-grade dollar bonds are mainly affected by benchmark interest rate, while high-yield bonds are mainly affected by credit spread. The benchmark interest rate is based on the US economic fundamentals, monetary policy and liquidity, and determines the long-term and short-term interest rate trends and bond curve patterns. Credit spreads are mainly affected by market risk preference and corporate fundamentals, and are composed of credit risk premium and liquidity premium, and are mainly affected by the former. In addition, the difference in financing costs at home and abroad and the expectation of exchange rate are also other influencing factors.
Figure 6: Impact factor of Chinese dollar bonds
Source: Public information compilation, China Merchants Bank Research Institute
From the historical trend, the maturity yield of investment-grade dollar bonds is dominated by the benchmark interest rate of US bonds, generally the benchmark interest rate plus liquidity premium. The issuing entities of investment-grade bonds have little difference in qualifications and credit. As long as there is no extreme liquidity crisis, the interest rate spread volatility range is relatively stable compared with high-yield bonds. The yield of investment-grade bonds is more converging with the benchmark interest rate of US Treasury bonds, so the investment opportunities of investment-grade dollar bonds can be judged from the trend of the US 10-year Treasury bond interest rate. The trend of high-yield dollar bonds is mainly dominated by Chinese dollar real estate bonds. The difference in issuer's credit risk is determined by the credit risk premium of individual bonds, and the volatility is closer to stock assets.
Figure 7: The yield on maturity of investment-grade bonds is consistent with the benchmark interest rate trend
Source: Bloomberg, China Merchants Bank Research Institute
Figure 8: High-yield bonds are greatly affected by real estate bonds
Source: Bloomberg, China Merchants Bank Research Institute
(II) The risk of falling US bonds is released, and Chinese dollar bonds have the opportunity to allocate left
Chinese dollar bond credit spread widens. At present, the upward yield on maturity of investment-grade bonds has driven the credit spread to widen. At present, the credit spread of investment-grade bonds has reached a higher level since 2013. There is limited room for continued broadening, the continued decline of investment-grade bond prices has also narrowed, and the margin of interest rate protection has increased; while the interest rate spread of high-yield Chinese dollar bonds is still adjusting, and the bottom of the price decline is still difficult to determine.
Figure 9: Investment-grade Chinese dollar bond spread (vs Treasury bonds)
Source: Bloomberg, China Merchants Bank Research Institute
Figure 10: High-yield Chinese dollar bond spread (vs Treasury bonds)
Source: Bloomberg, China Merchants Bank Research Institute
Outlook, US inflation has basically peaked, and the pressure on the decline in US bond prices has eased. Since July, CPI has continued to fall marginally from its highest point of 9.1% to 8.3%, but its stickiness is still high, and the long-term inflation expectations have risen. Employment data, as the leading indicator of the economic cycle, the U.S. unemployment rate in August was 3.7%, returning to the lower level before the epidemic, indicating that the labor market is still in short supply and the economy is still far from a substantial recession. Strong employment data provides room for interest rate hikes. Therefore, the Federal Reserve will maintain its tough interest rate hike policy to push up the unemployment rate and hit inflation to 2%. From the September Fed interest rate meeting dot chart, it is expected that the expected benchmark interest rate will rise to 4.25-4.5% and above at the end of December 2022. It is still possible to continue hikes in 2023 and keep policy interest rates at high levels. Rate cuts may not occur in 2024. The short-term market pricing for currency tightening expectations has not yet ended, and the 10Y interest rate of US Treasury bonds is expected to continue to rise. However, as the interest rate hike process enters the second half, the extremely urgent pace of interest rate hikes has also increased the probability of a hard landing in the economy coming early. The risk of a recession in the United States is getting closer and closer, and the room for long-term interest rates may not be large, with the high point at 3.8-4.0%. With the arrival of a downward trend in the US inflation and weakening of employment, the 10Y interest rate of US bonds will decline, the interest rate spread is expected to narrow, and the price of US bonds is expected to rebound.
To sum up, when the benchmark interest rate level is high, the yield on Chinese dollar bonds will also maintain a higher range. The allocation value of investment-grade dollar bonds with a high degree of yield trend and benchmark interest rates is gradually emerging, and it is currently a window period for the left to allocate/add to Chinese dollar bonds.
Figure 11: September FOMC meeting dot chart
Source: Federal Reserve, China Merchants Bank Research Institute
Investment opportunities and risks: Chinese dollar bond yields are at a relatively high level, and real estate default risk is still rising
(I) Chinese dollar bonds have coupon advantages over Chinese bonds
Figure 12: The difference between the yield of Chinese dollar bonds and domestic credit bonds turns from negative to positive (taking municipal bonds as an example)
Source: Wind, China Merchants Bank Research Institute
(II) Analysis of risk factors
In terms of municipal bonds, relying on the policy of stabilizing growth this year, the risks are relatively controllable than other industries in the context of weak momentum for economic recovery. In the general direction of controlling the increase in government debt, financing channels have tightened marginally, the epidemic has repeatedly aggravated the pressure of decline in fiscal revenue in most regions, the pressure of debt repayment has increased, and the risk incidents of domestic urban investment enterprises have increased. Since income such as land transfer fees are important resources that can be used for debt repayment, the exposure of regional risks in fiscal revenue that are highly dependent on land transfer fees has increased, and inter-regional credit qualifications continue to be differentiated.
In terms of financial bonds, the duration of stable growth and loose credit this year may continue. The issuance of US dollar bonds is an important channel to alleviate the pressure on banks' liabilities. State-owned banks are the main issuers of the financial sector, and the valuation pressure mainly comes from the risk of rising US bond interest rates. Small and medium-sized banks, especially entities closely related to the real estate business, have valuation pressure from the risk of default of real estate companies, and different driving forces have caused trend differentiation.
Figure 13: High-yield Chinese dollar bond price index
Source: Wind, China Merchants Bank Research Institute
Figure 14: Investment-grade Chinese dollar bond price index
Source: Wind, China Merchants Bank Research Institute
From the perspective of default situation, real estate Chinese dollar bonds occupy the vast majority of the default scale, and the default risk is mainly concentrated in real estate companies. As of the end of August this year, the default scale of overseas companies in China has been approximately US$37.3 billion, continuing to rise from previous years. Among them, the default scale of Chinese dollar bonds in the real estate industry exceeds 30 billion, and the default risk is still rising.
If the default amount accounts for the stock scale of Chinese dollar bonds (US$968 billion as of the end of August), the default ratio of real estate bonds accounts for 3.5%, and the default ratio of other industries is below 0.5%. Comparing the non-performing loan ratio of commercial banks at the end of the second quarter of this year disclosed by the China Banking and Insurance Regulatory Commission, , at the end of this second quarter, the default rate of the real estate industry is much higher than that of other industries and market averages, while the default ratio of other industries is lower than the non-performing loan ratio of domestic banks.
Figure 15: The scale of defaults for overseas companies in China has increased since 2022
Source: Bloomberg, China Merchants Bank Research Institute
Figure 16: The defaults for Chinese dollar bonds in 2022 are concentrated in real estate
Source: Bloomberg, China Merchants Bank Research Institute
For investors who want to participate in Chinese dollar bond products, if they are raised, participated, exited and deducted in RMB, they need to invest in financial instruments denominated in US dollars in overseas markets after exchange, and after obtaining foreign exchange profits, they need to re-exchange them into RMB. In the case of changes in the RMB exchange rate , this operating model needs to face investment risks caused by the exchange rate differences between the local currency and foreign currency compared with domestic market investment. In the next stage, under the combined effect of the strengthening of the US dollar, the inverted interest rate spread between China and the United States, and the weak domestic and foreign demand, the pressure on the depreciation of the RMB is still being released, thus creating a certain risk exposure.
The commonly used method of locking foreign exchange is to operate through foreign exchange forwards. The US dollar has continued to strengthen since this year. Therefore, forward ideas (USD against the offshore RMB swap price) continue to decline. Since May, the return on locking foreign exchange has turned positive to negative. At this stage, participating in investment may generate relatively high locking costs, about 100+bp. But in the long run, the RMB is expected to maintain a two-way fluctuation against the US dollar. The space for the US dollar to continue to strengthen will narrow as the interest rate hike ends, and the swap point is expected to turn positive, and the cost of locking the exchange rate will be reduced. Overall, it is recommended to choose time windows, rolling exchange locks and other methods to control exchange lock costs and reduce the exposure to exchange rate fluctuations.
Figure 17: The RMB still has certain depreciation pressure
Source: Wind, China Merchants Bank Research Institute.
Figure 18: US dollar against offshore RMB swap is negative to increase the cost of locking exchange
Source: Wind, China Merchants Bank Research Institute.
(III) Investment strategy: Mainly hold coupons for investment-grade US dollar municipal investment bonds and financial bonds, it is recommended to avoid or carefully allocate real estate industry bonds as described above, and focus on two major entities such as finance and municipal investment. It is recommended to temporarily avoid high-yield bonds.
The current investment-grade bonds have a certain attractiveness. As of mid-September, the yield level was around 5%, at the historical 90% quantile. Because the fundamentals of domestic and foreign bond issuing entities are the same, in the context of the current inverted interest rate spreads at home and abroad, Chinese investment-grade dollar bonds are 2% premium to domestic bonds, which is located in the historical 92% quantile, which has relatively obvious returns compared to domestic bonds.
Considering that the US Treasury yield has reached a historically high level this year, although the market still has room for fluctuation and downward in the future, the time when the US Treasury price fell the fastest, and it is currently in the window period for the left configuration. It is recommended to adopt a coupon strategy relatively appropriate. From a medium-term perspective, market interest rates may gradually fall from a high level, and some capital gains may be obtained under the premise that the risk of credit default is controllable.
Figure 19: Yield and spread level of Chinese dollar bonds
Source: CICC, China Merchants Bank Research Institute
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This issue author
China Merchants Bank Research Institute Beijing Branch (Investment Bank Department)
Suchang China Merchants Bank Research Institute Capital Market Researcher
suchang9898@cmbchina.com
He Jing Beijing Branch Investment Bank Department Product Manager
hejingdee@cmbchina.com
Kangling Beijing Branch Product Manager of Investment Banking Department
wuyp@cmbwinglungam.com
Liu Dongliang, Director of Capital Market Research Institute,
liudongliang@cmbchina.com
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China Merchants Bank, all rights reserved.
Editor in charge | Yu Ran
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