Finding value in China’s onshore bond market

In our global investor survey on Asian fixed income, 63% of global investors picked China bonds as a key strategy to invest in over the next 24 months despite the significant regulatory changes and the ongoing default risks faced by China’s property issuers. The fact remains that China bonds continue to appeal, and asset managers with mastery of the local market and issuers stand to benefit.

Dec 2021 | 5 min read

Early in the year, we gave our views on why China’s fast growing onshore corporate bonds offer opportunities. Since then, there have been considerable developments and volatility in China’s capital markets, triggered by regulations, deleveraging and defaults which has understandably dented investor sentiment. Nevertheless, we continue to see opportunities in the onshore market and regard this as an opportune time to add alpha on a selective basis.  

The total size of the onshore credit bond market is approximately CNY 50.1 trillion1; state owned enterprises (SOEs) and local government financing vehicles (LGFVs) represent the dominant issuers in this segment. LGFVs came into existence in the 1990s and were set up by local governments as a subset of SOEs to finance off-budget public investments. Following the 2008 global financial crisis. LGFVs became a key conduit to fund China’s infrastructure boom. With implicit guarantees from local governments in place, LGFVs borrowed heavily and easily.

Their growing debt levels have been a concern for some time now and Chinese authorities have been tightening their oversight over LGFVs. Additional guidelines were issued to banks and insurance institutions earlier this year to discourage new loans to LGFVs that have implicit guarantees from local governments, triggering concerns on LGFVs’ refinancing capability. The government also signaled there would be no bailouts for indebted LGFVs, causing some market volatility in the onshore market even though to date there has not been a default on a publicly listed LGFV bond.

Despite these ongoing issues, one cannot ignore the potential opportunities. For one, the LGFV market is too big to ignore; LGFV bonds account for more than half of the government-related issuance.2 There are about 5000+ LGFV issuers in the onshore bond market. Adopting a credit differentiation approach and tapping on deep local market knowledge is the best way to invest in this market.

Credit differentiation is crucial

Against this backdrop, it is important to assess the credit worthiness of LGFVs by determining the credit strength of its local government sponsor and the role it plays in supporting policy objectives. LGFVs typically finance public policy projects such as public infrastructure, affordable housing, public transport, primary land development, healthcare facilities, social services etc. These LGFVs are considered far more important than others that are pursuing commercial businesses and should continue to enjoy their respective local government’s support.

This then begets the issue of the local government’s capacity to support these LGFVs. Due to the centralised government regime, a local government’s position in the administrative hierarchy will determine its political, economic, and fiscal linkage with the central government and hence its capacity to support LGFVs.

Fig 1: China’s Administrative Hierarchy


Additionally, a local government’s fiscal position, debt obligations, health of its financial sector and ability will also determine its capacity to support its LGFVs. Higher tier governments also tend to have lower debt burden. See Fig 2. Since Nov 2020, provincial governments have shown an increasing willingness to support key LGFVs due to the likely severe repercussions of a default. This follows through from the default by the Henan province state-owned coal company. Onshore bond investors concluded that a potential default by one LGFV or local SOE would trigger a withdrawal of government support for the whole LGFV sector in the region. This severely hindered the LGFVs in that province to access funding and caused a regional financial crisis.

Fig 2: Leverage profile of LGFVs controlled by different of local governments (2019)


That said, one cannot assume that that a district or county government’s capacity to support LGFVs is tied to the provincial government. Different cities within the same province have different economic and credit profiles; some of the richest provinces have cities with below national average income levels.

Another point to note is the local governments’ ability to mobilise resources. Those that are burdened with non-performing bank debt and have highly indebted SOEs, or worse have a history of defaults by its SOEs will face difficulty in accessing emergency funding for LGFVs.

Implications for LGFV bonds

Going forward, our assessment is that banks would take a more cautious stance (and longer approval process) for both loans and bond investments for LGFVs, which may lead to a lower supply and higher issuance cost in the primary market for certain LGFVs. In fact, the supply of onshore LGFV bonds has fallen this year. See Fig 3. The weaker regions have not been able to issue new bonds in view of the tighter regulations.

Fig 3: Net onshore corporate bond issuance


The credit differentiation was seen at the funding level; the credit spreads of LGFVs in Shanghai, Guangdong and Beijing are close to zero while those in the weaker cities could see spreads north of 300 basis points. Despite this, the current yield level of LGFVs is below the five-year average, reflecting the continued support for this sector. Equally at this level, it is the only credit segment that is offering yields over CGBs.

Fig 4: China’s onshore bond yields


In terms of risk, we do not expect large scale defaults in this segment, nor we do anticipate defaults of important LGFVs. Still the changing regulations, longer approval process at banks and at the government level would lengthen refinancing process. As such we expect continued differentiation in this space which in turn comes down to our fundamental assessment of the importance of an LGFV and the long track record of government support.

We expect the LGFV market to continue to undergo more restructuring which will likely weed out the weaker players. Eventually the aim is to separate LGFV credit from the local government credit. This will render LGFVs to be treated at the same level as SOEs and privately owned enterprises (POEs). Ultimately, we reiterate what we stated in our earlier articles; the Chinese government has the political will and policymaking capacity to steer the market back into calmer waters. Previous experience has shown its ability to contain systemic risk and maintain overall financial stability.

For Use with Professional Clients / Qualified Investors Only. Not Approved for Further Distribution or Use with the General Public.

1 WIND, June 2021
2 BofA Global Research, July 2021

The information and views expressed herein do not constitute an offer or solicitation to deal in shares of any securities or financial instruments and it is not intended for distribution or use by anyone or entity located in any jurisdiction where such distribution would be unlawful or prohibited. The information does not constitute investment advice or an offer to provide investment advisory or investment management service or the solicitation of an offer to provide investment advisory or investment management services in any jurisdiction in which an offer or solicitation would be unlawful under the securities laws of that jurisdiction.

Past performance and the predictions, projections, or forecasts on the economy, securities markets or the economic trends of the markets are not necessarily indicative of the future or likely performance of Eastspring Investments or any of the strategies managed by Eastspring Investments. An investment is subject to investment risks, including the possible loss of the principal amount invested. Where an investment is denominated in another currency, exchange rates may have an adverse effect on the value price or income of that investment. Furthermore, exposure to a single country market, specific portfolio composition or management techniques may potentially increase volatility.

Any securities mentioned are included for illustration purposes only. It should not be considered a recommendation to purchase or sell such securities. There is no assurance that any security discussed herein will remain in the portfolio at the time you receive this document or that security sold has not been repurchased.

The information provided herein is believed to be reliable at time of publication and based on matters as they exist as of the date of preparation of this report and not as of any future date. Eastspring Investments undertakes no (and disclaims any) obligation to update, modify or amend this document or to otherwise notify you in the event that any matter stated in the materials, or any opinion, projection, forecast or estimate set forth in the document, changes or subsequently becomes inaccurate. Eastspring Investments personnel may develop views and opinions that are not stated in the materials or that are contrary to the views and opinions stated in the materials at any time and from time to time as the result of a negative factor that comes to its attention in respect to an investment or for any other reason or for no reason. Eastspring Investments shall not and shall have no duty to notify you of any such views and opinions. This document is solely for information and does not have any regard to the specific investment objectives, financial or tax situation and the particular needs of any specific person who may receive this document.

Eastspring Investments Inc. (Eastspring US) primary activity is to provide certain marketing, sales servicing, and client support in the US on behalf of Eastspring Investment (Singapore) Limited (“Eastspring Singapore”). Eastspring Singapore is an affiliated investment management entity that is domiciled and registered under, among other regulatory bodies, the Monetary Authority of Singapore (MAS). Eastspring Singapore and Eastspring US are both registered with the US Securities and Exchange Commission as a registered investment adviser. Registration as an adviser does not imply a level of skill or training. Eastspring US seeks to identify and introduce to Eastspring Singapore potential institutional client prospects. Such prospects, once introduced, would contract directly with Eastspring Singapore for any investment management or advisory services. Additional information about Eastspring Singapore and Eastspring US is also is available on the SEC’s website at www.adviserinfo.sec. gov.

Certain information contained herein constitutes "forward-looking statements", which can be identified by the use of forward-looking terminology such as "may", "will", "should", "expect", "anticipate", "project", "estimate", "intend", "continue" or "believe" or the negatives thereof, other variations thereof or comparable terminology. Such information is based on expectations, estimates and projections (and assumptions underlying such information) and cannot be relied upon as a guarantee of future performance. Due to various risks and uncertainties, actual events or results, or the actual performance of any fund may differ materially from those reflected or contemplated in such forward-looking statements.

Eastspring Investments companies (excluding JV companies) are ultimately wholly-owned / indirect subsidiaries / associate of Prudential plc of the United Kingdom. Eastspring Investments companies (including JV’s) and Prudential plc are not affiliated in any manner with Prudential Financial, Inc., a company whose principal place of business is in the United States of America.