A new voice sheds light on China’s bond market

In the investment arena, information that supports confident decision-making is arguably the most valuable currency - and nowhere is this truer than in China's bond market, which, despite its phenomenal recent growth, remains relatively opaque to many investors.

Participants at the recent Inaugural Pengyuan Credit Conference in Hong Kong made it clear that though awareness of the opportunities Chinese bonds present is growing, more insight into the market's unique composition and dynamics will be needed to take it to the next stage of development. And domestic ratings agencies will have a key role to play in this process.

As Tony Tang, Chief Analytics Officer at Pengyuan International, noted, investors frequently approach China's bond market full of questions. One concern is the gap between domestic, or national scale, credit ratings (NSRs) and the international, or global scale variety (GSRs) - and whether these gaps mean NSRs are not credible.

In fact, "the perception of one being better than another is unfair," as they serve essentially different purposes, Tang said. While GSRs are designed to be comparable across industries and countries, NSR rankings apply only to the domestic market, and need to be considered exclusively in that context. Clearer linkages between NSRs and GSRs may be developed, but this will require new research, criteria and models and is likely to be a long-term project.

Even now, however, "the relative rankings of NSRs (in the China market) do carry information about Chinese credit risk, so you should pay attention," Tang pointed out. Pengyuan's ratings, for example, benefit from the company's extensive investments in technology infrastructure, including a "crawler" that constantly searches vast pools of data for changes or events pertaining to Chinese credits. This has created an "early warning system" that can flag events that may have credit implications, such as a share sale by a key executive, well ahead of the market.

These tools, combined with an analytical approach that factors in stress-tested criteria such as likelihood of default, recovery prospects and credit stability over time, produce ratings that shed light on the relative quality of Chinese credits, Tang said. Investors "just need to be careful with the interpretation."

To default or not to default

 Questions also surround the stability of China's bond market. In the local government financing vehicle (LGFV) segment, for example,  "default or no default" is the big question for 2018, according to Liang Zhong, Managing Director, Sovereign and Public Finance Ratings, Pengyuan International. While a real-time poll showed that almost half of the conference participants felt it would take more than two defaults a year to trigger sector-wide funding problems, it also pointed to a hunger for more information on LGFVs - particularly on their debt burdens and related liabilities.

In Pengyuan's view, a public bond default this year is "possible but not probable," Zhong said. The government is concerned about rampant LGFV borrowing and could allow a public bond default to send the message that these debts are not implicitly guaranteed, but is also conscious that the risks of "shock therapy" could outweigh the benefits, making gradual tightening more likely.

Perhaps the more pressing question is where a public bond default may occur - and this is where regional differentiation based on extensive data mining is necessary. As local administrations can "window dress" standard metrics like GDP growth figures, Pengyuan overlays these with additional calculations and location-specific knowledge to produce more accurate indicators. "Experienced analysts know where to dig out the information, (and) how to pull it together to create an insightful picture," Zhong noted.

Financial sector in focus

There are also rising demands for clarity on credit quality in China's vast financial sector, which, after an "astonishing" pace of change in the last decade, spans everything from the "Big Four" institutions to peer-to-peer lenders. All these fall on different places on the risk and capital resilience spectrum, noted Stanley Tsai, Managing Director, Financial Institutions Ratings, Pengyuan International.

Overall, the prospects for the sector in 2018 are relatively stable. A regulation tightens, further growth in the shadow banking system is likely to slow and more funds flow back from the "murkier" segments of the industry, such as wealth management products, to "core" parts such as loans.

However, market observers may not be accurately assessing where the threats to this stability lie. Another real-time poll showed the audience felt asset quality was the biggest potential risk to Chinese financial institutions, whereas in Pengyuan's view liquidity is a greater concern - particularly for smaller institutions.

"Watch liquidity very carefully," Tsai said, noting a missed interbank payment by a small city or rural institution would be one key sign of stress. Again, this requires consistent, bottom-up monitoring of industry data. If such an event occurs, "what matters will be the direction and strength of the regulatory response".

Offshore issuance rush creates risks

In offshore Chinese corporate bonds, 2017 was a record-setting year, when total issuance more than doubled year-on-year, according to Winnie Guo, Director, Corporate Ratings at Pengyuan International. High-yield, particularly property, issuers are rushing to take advantage of cheaper fundraising conditions, but narrowing yield spread between onshore and offshore bond markets argue for a reassessment of risk - meaning defaults.

While default rates are likely to remain low, the government's continued push for deleveraging and financial stability make a certain level almost inevitable in 2018 and 2019. That means the risks around individual credits should be examined carefully, especially in vulnerable sectors like property, Guo noted.

Pengyuan has adopted a unique approach to capturing these risks, factoring in credit ratios, projected recovery rates, and bottom-up examination of shareholder structures. Fragmented structures, common among privatised SOEs, can lead to "hostile acquisitions or management disputes, which might trigger changes of control and lead to default or near-default," Guo said. These risks "might not be captured by the (standard) credit rating, and surprise the market from the downside."

Assessing asset-backed securities

Asset-backed securities (ABS) are another segment of the debt market that has seen "tremendous growth" over the past few years, fuelled by market forces and robust demand, according to Ke Chen, Senior Director, Structured Finance Ratings, Pengyuan International. However, this growth has come with challenges, notably a lack of transparency and information around this relatively new asset class.

"Due to the short history of the market, it doesn't have sufficient data to analyse the risks," Chen noted. In addition, "performance has not been tested in a stressed credit environment".

Pengyuan is addressing this "information asymmetry" between borrowers and investors using its data, models and credit analyses. These assess both quantitative factors, such as recovery rate forecasts, and qualitative factors like legal and counterparty risks, leveraging Pengyuan's considerable knowledge and technology resources. This will contribute to both the development of the market and future stability, since "the market itself can't address these frictions," Chen explained. "Ratings agencies should improve the information quality of credit ratings to help address the challenges and fill the information gaps between issuers and investors."

What investors want

A panel of veteran investors from leading institutions such as HSBC Private Bank, Prudence Investment Management and Income Partners Asset Management made it clear investors are both conscious of market information gaps and keen to see them resolved. Vijay Chander, Executive Director, Fixed Income at the Asia Securities Industry & Financial Markets Association, cited the lack of transparency and "a formalised bankruptcy process that follows a debtor hierarchy" as two of the biggest barriers to the bond market's development.

China's bond market has become "too big to ignore", and can offer higher yield opportunities, noted James Hu, Executive Director & Senior Portfolio Manager at Income Partners. At the same time investors "do find it difficult to access the market and information, and that's why we need a specialised team like Pengyuan".

Investors are increasingly looking to domestic ratings agencies for more than data or opinions, noted Chad Liu, Chairman and CIO at Prudence. Their real "value adds" are capabilities in analytics and access to issuers in a market where connections are important. "This isn't very high tech, but it's actually very essential," he said.

According to Jonathan Hu, the Chief Executive Officer of Pengyuan International, "in order to make your investment decisions, it's best to talk to the local experts". And it is here the historically domestic focus, expertise and networks of Chinese ratings agencies begin to look like a distinct advantage in building and disseminating knowledge on a rapidly developing market.

Pengyuan is one of the earliest credit rating agencies established in mainland China. During its 24-year history, Pengyuan has carried out more than 35,000 credit rating projects. Based on the extensive database and advanced information capability of its shareholders, and the professional analytical team that combines international capital market expertise and Chinese know-how, Pengyuan International is dedicated to provide creditable and high-quality credit rating service for global investors.

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