Photographer: Andrew Harrer/Bloomberg

China's Booming Dollar Bond Market Faces Threat From Within

  • Chinese buyers dominate the country’s dollar-bond market
  • Homogenous investor profile raises risks: ANZ’s Gallimore

China’s dollar bond market has a diversity problem.

As borrowers raised a record $51.7 billion in dollar-denominated debt this year, Chinese banks bought about half of the notes, according to UBS Wealth Management. U.S.-based money managers only got access to 7 percent of the deals, down from 46 percent in 2014, data compiled by Bloomberg show.

The domination of China-based investors is fueling angst about the potential fallout if they all get cold feet at once, especially with $195 billion of dollar notes maturing over the next three years. Risk of a regulatory crackdown on wealth management products and a strengthening yuan are near the top of the worry list: after three years of depreciation spurred Chinese buyers to load up on dollar assets, the currency’s gains in 2017 put that trend in jeopardy.

“Aside from market and credit risks, the biggest risk that could force Chinese investors to cut dollar-bond holdings is yuan appreciation,” said Wu Xiangjun, an overseas bond fund manager in Shanghai at Guotai Asset Management Co.

The yuan is expected to hold its own against the dollar, while retreating against everything else this year: read more.

Should Chinese investors have a change of heart when it comes to the country’s dollar securities, it would have an outsize impact as the buffer that investors from elsewhere used to provide has shrunk. Chinese companies have reduced the amount of bonds that can be issued to U.S. investors as demand at home diminishes the need to market the debt abroad and pushes down spreads.

Average yield premiums on China’s corporate dollar bonds have fallen to near their lowest level in at least a decade, dropping 21 basis points this year, according to Bank of America Merrill Lynch indexes.

Raja Mukherji, Pacific Investment Management Co.’s Hong Kong-based head of Asia credit research, said he is carefully monitoring for any developments that could derail Chinese investor appetite for the nation’s dollar debt. Chinese banks often repackage the securities in to WMPs sold to individual investors seeking higher yields.

China has been steadily tightening conditions in money markets as officials seek to rein in the record leverage built up since the global financial crisis. Any “massive increase” in interest rates could lead to an unwinding of demand from wealthy Chinese investors for dollar debt, said Mukherji. “Secondly, if the Chinese government imposes further restrictions in terms of what onshore investors can buy -- those are the two risks I see,” he said.

Click here for a round up of China’s capital controls.

While the risk of a drastic shift by Chinese investors is low, regulators do pose a threat to the dollar financing channel, says Qiang Liao, a Beijing-based S&P Global Ratings credit analyst.

“The risks that could derail it are mainly to do with China’s policy setting which can cut off the funding chain from big Chinese banks to speculative-grade issuers via nonbank financial institutions,” he said.

The top-down nature of China’s dollar-bond buyers also leaves the market vulnerable to a policy shift from the authorities, according to Owen Gallimore, head of credit strategy at Australia & New Zealand Banking Group Ltd. in Singapore.

‘Very Homogenous’

While the legion of home-based investors “insulate” Chinese issuers from external risks outside the region, the “very homogeneous” nature of those China-based bids -- which are mostly made up of bank treasury desks and wealth management firms -- poses risks.

The government’s deleveraging campaign has ramped up onshore borrowing costs, with benchmark 10-year yields near their highest level in more than a year. Local bonds posted their worst performance in at least 12 years in the fourth quarter.

“If the onshore bond market continues to struggle they might be told to redirect their investments from the offshore market to the onshore market,” he said.

— With assistance by Denise Wee, Judy Chen, and Narae Kim

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