Who Issues Bonds In Asia?


Date: 27.02.2018

The Chinese bond market is now open to foreign investors.  However, many investors mistakenly think this US$9 trillion bond market works like a free market. It does not. Bond markets across the entire region are manipulated by governments.

Let’s say you own a company in a developed economy like the U.S. If you want to raise capital, you can take out a bank loan, issue a bond or sell shares on the stock market.

A business owner in an emerging Asian economy however, has fewer options.

In Asia, issuing corporate bonds is not efficient. Governments issue the vast majority of bonds instead. Adding Asian bonds to your investment portfolio means you are exclusively investing in governments. This has its own risks and opportunities.

How bond markets develop

Bond markets can only develop if businesses can issue bonds that raise cheaper capital than what they can get from banks.

In the finance world, banks act as a go-between. They get money from deposits and lend it to borrowers. But most deposits are short term. This makes long-term lending for bonds a risky business for banks.

This is where bonds prove their worth. Corporations, insurance companies and pension funds have the ability to issue long-term bonds without running too much of a risk and they can raise capital cheaper than banks can.

At least, that’s how the system works in a developed economy.

But in emerging economies, like the one in China, bond markets lack the risk and the supply and demand mechanism that drives the market forward. This leaves capital markets in emerging economies in a rudimentary state.

Check out the chart below and compare the difference between the capital market of a developed country like the U.S. and the capital markets across Asia. Asian bond markets accounted for only 23.3% of the GDP in 2015. This is tiny compared to the U.S. bond market which accounted for 117.1% of its GDP in 2015.

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US capital market vs Asia capital market

So why aren’t China’s bond markets driven by supply and demand? To get to the bottom of that, we need to take a close look at bond yield curves.

Asia’s meaningless yield curve

The points on the yield curve represent bond interest rates over time, depending on when they mature. On a normal yield curve, interest rates increase the longer you hold on to the bond. You can see an example of a normal yield curve below.

In developed economies, supply and demand determines the interest rate curve of government bonds, issued by the country’s ministry of finance. For example, in the U.S. the curve includes prices of T-bills, T-notes and T-bonds.

Interest rates on government bonds are the lowest, as they are the most reliable issuer of bonds on the market. They are also a point of reference for other bond issuers.

Bonds issued by the Chinese Ministry of Finance (MOF) unsurprisingly have the highest credit rating and the lowest interest rates in the country. This is shown in the graph below.

Corporate bond interest rates in developed markets usually follow MOF issued bonds.

But in the graph above, that doesn’t seem to be the case. The reason for that is that interest rates of Chinese corporate bonds actually follow the Chinese central bank’s lending rate. On the graph below you can see how the deposit rate and the lending rate of the People’s Bank of China (PBOC) - this is the Chinese central bank -mirror each other over time.

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Bank Deposit Rate vs. Lending Rate

You see, the PBOC controls the spread between deposit rates and minimum bank lending rates. They do this to assure their lenders a minimum profit of 300 basis points or 3%. In developed economies, the interest rates are determined by the market.

So when a Chinese bank wants approve a bond, it will compare its potential return with that of a bank loan of similar maturity and a similar borrower, ignoring the MOF yield curve. Companies who want to issue a bond will follow the same reasoning. This ultimately determines the prices of bonds in China.

This makes the MOF yield curve in China completely useless. Chinese companies could just go the bank for a loan at the same rate. Loans are often granted much quicker than bonds are issued. This results in uncompetitive prices, an acute lack of demand and an underdeveloped market. The graph below clearly shows this.

Companies may have issued over RMB 15 trillion yuan (about US$2.2 trillion) worth of corporate bonds, but the Chinese government has issued more than double that amount. Including policy banks, the central government, local governments, and some state-owned commercial banks it issued a total of RMB 35 trillion yuan (about US$5.3 trillion) worth of bonds. Not to mention the more than 16 trillion RMB (around US$2.4 trillion) worth of debt mostly issued by SOEs.

What are the unique risks in a government dominated bond market?

For starters, liquidity (how easily your bond can be converted to cash) is a big problem.

Despite the market for government bonds having more than 9,000 members that hold over US$500 billion in bond value, the entire China interbank market recorded a mere 1,550 trades in 2016. The U.S. Treasury by comparison records 600,000 trades per day on average and has US$1 trillion in value.

By analyzing a bond market’s turnover ratio, you can measure its liquidity.

On the graph below, you can see the turnover ratios from Asian countries’ government bonds. Japan’s stands at 1.2, the most liquid in the region. At 0.4, Myanmar’s is the least liquid. But even Japan’s ratio looks feeble compared to the 2.5 ratio the U.S. Treasury market had in the first financial quarter of 2017.

One Road Research

Another reason for these countries’ stagnant interest rates is the fact that bond prices are hard to determine when they aren’t being traded.

Then there’s the way risk is measured in Asia. Their credit ratings agencies don’t shy away from compromising accuracy in favor of politics.

Just look at China.

Their domestic rating agencies give almost 90% of China’s domestic bonds an AA rating. However, firms with an AA rating frequently default in the blink of an eye.

Should I invest?

Dubious ratings, low liquidity and dominated by governments. This isn’t what appeals to your everyday investor.

But we are sold on China’s bond market and we believe now is the moment to get into it - before anyone else does.

Stay tuned, because next time we’ll expose the ones buying all of the government’s debt and tell you why you better not miss out on buying Asian bonds.


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