A sheep in goat’s clothing
In the West, ‘sorting the sheep from the goats’ is a common metaphor for separating the good from the bad. The Chinese language, however, does not differentiate between the two species. So as the year of the sheep (or goat) approaches, it is perhaps understandable if some investors are asking which sort of beast China’s offshore dim sum bond market represents. With China’s growth slowing, with the renminbi down -2.3% against the US dollar in the offshore market over the last three months and with renewed doubts about the quality of issuers following problems at Hong Kong-listed property developer Kaisa, some are asking whether the dim sum sheep is really a goat.
As in any bond market, there are three different elements to assess: duration, quality and currency. Let us review each in turn.
Duration. For the six months to the end of January, being very long duration was the right bet in almost every bond market in the world. To our mind, long-dated bond yields collapsed for two reasons:
1) The bursting of the oil bubble. The bursting of any bubble is deflationary as it implies the write-down of a large amount of capital. But the bursting of the oil bubble is doubly deflationary: not only will we see large capital write-offs, but the lower oil price has had an immediate impact on consumer inflation measures all over the world.
2) The European Central Bank’s quantitative easing. Historically, global bond markets have tended to follow the lead set by US treasuries. But in the last six months we saw this historical relationship upended as the market ‘front ran’ the ECB’s QE program. As bond yields across Europe cratered, along with the euro, investors clearly felt that taking on more duration risk in the US, UK, Asia and elsewhere made excellent sense. As we look at it, this ‘duration party’ has now come to an end. Currencies are broadly stabilising and bond yields are no longer falling, so it looks as if the time to put on duration risk is behind us. Of course, Chinese fixed income investors never got to party as hard as everyone else in recent months, for the simple reason that the amount of long-dated paper in the dim sum market is very limited. But what goes around comes around, and the ‘retour du baton’ could well work in favour of shorter-dated dim sum bonds over the coming months.
Quality. There was a notable sell off in low-rated instruments in late 2014 and early 2015, mostly in response to the Kaisa ‘bust’ and the perception that a lot of property paper could be due for restructuring. Never say never (as the latest headlines about the magnitude of Kaisa’s debt pile remind us). But it still seems more likely that white knights will be pushed forward to bail out creditors at the last minute-the last thing Beijing wants is a series of scandals to undermine the credibility of its brand new bond market. It is even possible that the authorities could ease policy to help the guys who are in trouble-Beijing followed November’s rate cut with a reduction in bank reserve ratios this month. Having said that, these cuts reflect the reality that Chinese growth is slowing. The key question is whether it is slowing enough to trigger bankruptcies in the dim sum market. We do not think so. Instead we would argue that, in the post Kaisa sell-off, investors have been too ready ‘to throw the baby out with the bath water’. For investors with knowledge of the risks of individual credits, the prospects of picking up some decent yields look pretty good. (Granted, you could say the same about US high yield. In this sense China is hardly unique.)
Currency. This is where things get interesting. How much, if at all, will the renminbi go down against the US dollar over the coming year? In the last three months the Chinese currency has lost -2.3%, and stands close to a 2.5-year low. The most important thing to note is that unlike the fall that took place this time last year, it can’t be said that this fall reflects a desire by the People’s Bank of China to shake down overleveraged, long renminbi speculators.
This time around the fall is market-driven. That troubles the bears. However, the ultimate arbiter of the renminbi’s exchange rate is not the market, but the PBOC. And when it comes to exchange rate policy, the central bank has an over-riding interest in keeping the renminbi stable against the US dollar, both to further its long term strategic aims and to deter mass capital flight lest it trigger domestic financial instability.
In conclusion, viewed though the triple lens of duration, quality and currency, the current opportunity set in both high yield short-dated paper and in long-dated renminbi government bonds remains attractive - especially on a structural basis for investors based in the euro, British pound or yen. In fact, following the recent ‘counter-trend’ dip in the renminbi against these three currencies, investors should ask themselves whether over the next year the dim sum market will actually prove to be a sheep in goat’s clothing.