Funds Exit Opening Door to China Bond Market as Risks Escalate

  • January's $7.6 billion foreign selloff double August's number
  • Foreign funds `pulling money out,' not sending it in: Aberdeen

China is opening its bond market to foreign investors just as they head for the exit at a record pace amid warnings of rising debt risks.

Global funds’ holdings shrank by a record 49.6 billion yuan ($7.6 billion) to 553 billion yuan in January, Chinabond data going back to July 2014 show. That’s more than double the 22.7 billion yuan of net sales in August, when China shocked global markets by devaluing its currency. Aberdeen Asset Management Plc says investors are still withdrawing money, after the yuan slumped 3 percent in the past six months. Moody’s Investors Service Inc. cut China’s credit outlook to negative from stable on Wednesday.

QuickTake China's Pain Points

“They’re pulling money out of markets, not sending it in,” said Edwin Gutierrez, London-based head of emerging-market debt at Aberdeen, which oversees $428 billion globally. “With sentiment toward China so poor and people nervous about the currency, I don’t see a wall of money heading in.”

China took a major step toward giving foreigners freer access to the world’s third-largest bond market last week, three months after the International Monetary Fund decided to admit the yuan into its basket of reserve currencies. Chinese leaders want global funds, which hold 1.6 percent of the $5.4 trillion outstanding debt, to play a larger role to increase the yuan’s global usage, bolster the currency’s value and draw in more money to counter the worst economic slowdown in a quarter century.

While the yuan rebounded in February, it is still down 4.3 percent in the past 12 months to 6.5525 a dollar in Shanghai. The currency will weaken 5 percent to 6.9 per dollar this year, weighing on investors’ total returns, HSBC Holdings Plc wrote in a Feb. 24 report.

Market Opening

Offshore commercial banks, insurance companies, brokerages, fund-management houses as well as pension funds will no longer require quotas to invest in the interbank bond market, the People’s Bank of China said in a Feb. 24 statement. Freer access will help the nation’s bonds gain entry to global indexes, bolstering appetite for the securities as a restructuring of local-government debt leads to record issuance.

Inflows will be dominated by central bank reserve managers in the near term as yuan weakness and a lack of hedging tools discourages foreign buying, Deutsche Bank AG wrote in a Feb. 25 report. The currency will join IMF’s special drawing rights basket in October with a 10.92 percent weighting. That will boost foreign ownership to as much as 10 percent of yuan bonds in five years, implying capital inflows of about 10 trillion yuan, the German bank estimates.

“Bond outflows were probably lower in February,” said Frances Cheung, the Hong Kong-based head of interest-rate strategy for Asia ex-Japan at Societe Generale SA. “However, before growth rebounds on a more sustained basis, there is probably continued capital-outflow pressure from emerging markets including China.”

Allocators ‘Nervous’

While China offers the highest yields among the world’s major economies, Pacific Investment Management Co. and Schroder Investment Management Ltd. said last week that exchange-rate risk is damping global demand for Chinese assets.

“The authorities introduced volatility into what was a very low volatility market, and that made a lot of big institutional allocators nervous, not to mention you’ve got some of the big sovereign wealth funds with massive losses,” said Aberdeen’s Gutierrez.

The yield on 10-year government bonds is 2.89 percent, while similar-maturity notes in the U.S. and Japan yield 1.83 percent and minus 0.03 percent respectively. China’s benchmark yield was as high as 3.70 percent in April last year. Three-year corporate bonds rated Aaa yielded 3.1 percent, up six basis points this year, after declines of more than 300 basis points in 2014 and 2015.

Moody’s cut its outlook on China’s Aa3 rating, citing rising government debt and contingent liabilities, a drop in reserve buffers due to capital outflows, as well as policy, currency and growth risks. Foreign-exchange holdings shrank $99.5 billion in January to $3.23 trillion.

Credit Risks

China’s creditworthiness is worse than that of the Philippines, a country rated five grades lower at Moody’s Investors Service. The cost of insuring China’s five-year sovereign bonds has risen 23 basis points to 131.5 this year, while Philippines’ credit-default swaps on similar-maturity government debt added six basis points to 113.9.

At least seven Chinese companies defaulted on domestic notes last year after the authorities allowed the first such failure in 2014. Baoding Tianwei Group Co., a maker of electrical transformers that last year became the first state-owned company to renege on onshore debentures, again failed to repay bonds that fell due last week. Dye-and-paint maker Yabang Investment Holding Group Co. couldn’t make full payment on commercial paper due Feb. 9.

This year’s trading is going to be challenging and it will be “very, very hard to do well in the market,” said Liang Weihong, manager at Huashang Fund Management Co.’s $336 million Double Bonds Plenty Income Bond Fund A, which returned a top-ranking 33 percent last year.“The alarm for further declines in the yuan hasn’t been cleared.”

Liang said he would stick to top-tier bonds in industries with better corporate governance and reduce positions in smaller companies when appropriate as credit risks emerge. The yield on three-year AA rated Chinese corporate bonds has slumped to 4.04 percent from as high as 5.74 percent 11 months ago.

“For the bold and the brave, buying into a bond bubble in an over-valued exchange rate might look worth chasing a few basis points for,” said Michael Every, the Hong Kong-based head of financial markets research at Rabobank Group. “When you see how the stock market debacle played out, and you see how rich valuations are of corporate bonds, why risk it?”

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