Investing in Chinese Offshore USD Bonds: Opportunities and Prospect

2020 has been a rollercoaster year for the Chinese offshore USD bond market. Under the combined effect of tight USD liquidity and market concerns about corporate fundamentals following the COVID-19 outbreak in early 2020, the Chinese offshore USD bond market plummeted in March. But it soon regained strength for a strong, record-setting rebound. Just as the pandemic began to subside, credit risk events (e.g., credit defaults of Brilliance Auto and Yongcheng Coal & Electricity Holding Group) hit the market hard, testing investors’ research depth and investment capabilities to the limit. In the eyes of Yolanda Ye, Head of Fixed Income and Multi-Asset at Zhong Ou Asset Management International Limited, although there was little chance to emerge unscathed from the systemic risks in March 2020, it was still possible to gain early insight into the credit risk of a company through thorough investment research and adaptive use of overseas resources. Despite the ups and downs in 2020, Chinese offshore USD bonds still bring excellent investment opportunities and returns to professional long-term investors.

Chinese offshore USD bonds are becoming increasingly important in the Asian market and increasingly attractive to domestic investors due to their high liquidity 

What are Chinese offshore USD bonds, exactly? As the name suggests, they refer to USD-denominated bonds issued by Chinese entities in the offshore market. Among the issuers, the majority are regional or industry leaders that have been running a healthy business model, enjoying ample bank financing options and government support, and featuring a good credit profile and low risk of default. As such, the USD bonds they issue are increasingly favored by overseas institutional investors and a major part of an overseas strategic asset allocation plan.

Chinese offshore USD bonds took off in 2010 and have been maintaining the growth momentum ever since. As of the end of November 2020, increment issuance of offshore USD bonds by Asian companies was just shy of USD350 billion, of which nearly 60% were issued by Chinese companies. This shows that Chinesefunded companies have been eager to tap the overseas financing market.

Because of their more diverse composition, overseas markets tend to have higher liquidity compared with domestic markets. We have said earlier that the biggest differentiator between a domestic bond issue and an overseas one lies in market participants, who have a decisive effect on a bond market’s liquidity structure. While China has two bond markets—exchange market and interbank market—the latter dominates in volume. The interbank market is mostly for domestic banks, and this homogeneous composition leads to homogeneous investment decisions—any market movement will trigger substantially the same response, whether to buy or to sell, thus creating a one-sided and liquidity-strained market. This liquidity situation is further exacerbated by market inactivity, as holding-to-maturity is still the mainstream practice in China. 

Overseas bond markets are wholly different: almost all bonds are traded in the OTC market, which admits a more diverse and global investor base as any individuals or institutions can trade as long as they meet the criteria for professional investors. In terms of investment style, overseas fund and asset management companies—the main investors of Chinese offshore USD bonds—are mostly active managers and traders who eschew the holding-to-maturity strategy. Their different trading objectives lead to different trading strategies, and the resulting two-way liquidity fuels market participation and activity.

The finer-grained distribution of overseas ratings helps improve analysis on nongovernment-backed bonds (aka “credit bonds” in China) 

The more mature overseas credit rating mechanisms have also boosted market confidence in investing in Chinese offshore USD bonds. In the domestic market, bond ratings are weakly stratified. Absent of special circumstances, most bonds are given an investment-grade rating of AAA, AA+ or AA; those rated at or below AA− are regarded equally as high-risk investments. Moreover, domestic agencies do not adjust their ratings frequently enough to reflect the latest market conditions. For these reasons, most of the investors that need further insight have to rely on their internal research teams and develop in-house credit analysis frameworks.

Things are different in overseas markets. The rating standards of the three international agencies, namely Standard & Poor’s, Fitch Ratings, and Moody’s, are widely accepted. Ratings are divided into 6 major and 18 minor categories, ranging from CCC (lowest) to AAA (highest), which provide a finer-grained differentiation of the credit quality. Furthermore, the three rating agencies closely track the fundamentals of issuers and make prompt adjustment, so that their ratings reflect the current realities and can better inform the timely decision-making by investors. For instance, in the domestic market, China Evergrande Group has maintained a steady issuer rating of AAA, even after sharp revisions to the group’s valuation in the secondary market. But Moody’s had downgraded the group’s rating outlook to negative as early as June 2020. Another example is China Fortune Land Development, whose outlook was also downgraded to negative by Moody’s in September 2020, while domestic rating agencies did not make any adjustment until January 2021, nearly concurrent with the subject company’s valuation correction in the secondary market. These examples show that overseas rating outlooks, with their frequent updates, can provide valuable information to portfolio managers and analysts. And Chinese offshore USD bonds benefit from the same rigorous rating-review protocol which facilitates informed investment decision-making.

Credit bonds are prized by overseas investors 

In China, government-backed bonds (aka “rate bonds”)—those issued by the central government, local government financing vehicles (LGFV), policy banks and the like—are the go-to choice for investors and thus much more liquid than credit bonds. But outside China credit bonds dominate, accounting for most of the more-liquid varieties and representing a broader and more balanced range of industries. In terms of the industry distribution of newly issued Chinese offshore USD bonds (see the figure below), 30% of the increment is contributed by financial institutions, 25% by real estate companies, and around 30% by industrial companies (including SOEs and LGFVs). 

High yield is another big draw for Chinese offshore USD bonds

Chinese offshore USD bonds notably outperformed domestic credit bonds in 2020. The return on high-yield and investment-grade varieties hit 7.13% and 6.32% respectively, in line with the general trend that Chinese offshore USD bonds usually give a higher payout than onshore RMB bonds. Taking the longer historical perspective of from 2012 and onward and with currency hedging taken into account, offshore investment-grade credit bonds have a 0.5–3 percentage-point higher yield than domestic AAA-rated credit bonds, and for offshore high-yield credit bonds, the yield spread widens to 2% to 12% (mostly due to the financing restrictions on real estate companies in China). This “equal credit risk, higher investment return” characteristic adds to the appeal of Chinese offshore USD bonds.

For their high liquidity and diversity, Chinese offshore USD bonds are also drawing Chinese investors, among whom are: 1) banking institutions (the “big four” state-owned commercial banks, joint-stock banks, urban commercial banks, etc.), which invest through their asset management divisions and wealth management subsidiaries or with own funds; 2) insurance companies, mostly for asset allocation; 3) enterprises (central SOEs, local SOEs, etc.), which invest through their overseas cash pools (proceeds from overseas IPOs and bond offerings) to boost earnings; and 4) trust institutions, high-net-worth individuals, etc.

Yield Comparison of Investment-Grade Credit Bonds    Yield Comparison of High-Yield Credit Bonds

Chinese offshore USD bonds still hold an edge in mid-to-long-term allocation; for shortterm allocation, we are cautiously optimistic 

We believe that the following factors will have a major effect on the performance of Chinese offshore USD bonds in 2021:

1) U.S. monetary policy, which will directly affect the interest rate and liquidity of the USD. Market expects the U.S. to maintain a generally loose monetary policy in the next 2–3 years. As the Fed has hinted that there would be no rate hikes before 2023, short-term interest rates should edge closer to the federal funds rate in the next two years. The long-term rates are expected to rise as wider vaccine rollout will help control the pandemic and allow major countries to restart their economy. But despite the gradual recovery of economic activities, the Fed will not be hasty to tighten its policy, and Yield Curve Control is also on the table if the long-term rates show too much gain. In this case, the long-term rates will eventually rise only slightly. In addition, the market is becoming more confident about the fundamentals given the U.S. Senate’s early-2021 approval of the USD1.9 trillion stimulus plan and the improving pandemic situation in Europe and America.

2) China-U.S. relations. In short, we don’t think Biden’s election will completely reverse the anti-China sentiment in the U.S. stoked up during Trump’s presidency. But at the same time, we believe that the situation should at least not get worse, and that instead of imposing stricter sanctions on China, the new administration is likely to maintain the status quo or somewhat ease the tension with China. Because American investors are mostly holding investment-grade bonds issued by Chinese central SOEs and TMT companies, they will be forced to unwind their positions should further sanctions do occur, which will drive down bond prices. Therefore, in the short term, we recommend avoiding issuers that may receive sanctions and looking for investment opportunities from sanction-induced undervalued assets. 

3) The financing environment in the domestic market. The financing environment of the domestic credit market directly affects the movement and sentiment of the Chinese offshore USD bond market. We will track the domestic credit market closely in 2021 and proceed prudently. In the short term, the overall market sentiment will be stable with the post-pandemic economic recovery. China’s central bank expects to maintain a “reasonable and moderate” monetary policy, and the credit spread will decline. The market default rate is estimated to hover at the current level of around 1.0%, but credit polarization will continue. We closely monitor changes in company fundamentals and rating updates from overseas agencies. With a high rate spread, traditional industries and LGFVs and SOEs in underdeveloped areas will continue to struggle to deleverage, and default looms over the less robust /qualified ones. In terms of information gathering, attention should be focused on domestic default events and regulatory response. As bond defaults become a normal part of market activities, systemic risks will be less likely to flare up.

4) The COVID-19 pandemic. China has successfully prevented a Covid resurgence through quarantines, travel restrictions, and the stay-put policy during the Chinese New Year. But these measures are not permanent solutions. A full restart of the economy ultimately hinges on the effectiveness of the vaccine. So far, the global pandemic situation is improving with the vaccine rollout: Europe and the U.S. are seeing fewer new cases; and a similar downward trend is observed in all emerging countries except Turkey, where the pandemic is bouncing back. While a general economic recovery is expected, we will continue to monitor the divergence of countries owing to differences in vaccination speed and stimulus policies.