As the weight of Chinese bonds weighs on global bond indices, not allocating to China is seen as an active decision, but lending to Chinese companies and participating in Chinese markets has a set of particular characteristics.
When assessing governance, Donald Amstad, global head of client growth at Aberdeen Standard Investments points out language skills are critical to sourcing high quality information from Chinese businesses.
“So few foreigners speak, read or write Mandarin fluently, so by definition all the information you’re getting is second-hand,” he says.
“If you’re looking at China, it’s very important you build a team who can access information first hand.”
Investors with an appetite for emerging market debt must distinguish between local currency bonds and US-denominated stocks, Amstad says.
In China, there are onshore bonds denominated in CNY, including government bonds, quasi-government bonds, and bonds issued by state-owned enterprises and other companies.
Then there’s the US-dollar bond market offshore; issued from property development companies and, rarely, from the sovereign itself, which trade as a spread over US Treasuries.
“These risks are different, you’re either taking Chinese currency risk or US Treasury interest rate risk,” Amstad says.
When assessing a passive approach in China, Amstad suggests a pure Chinese government bonds benchmark, which misses the credit spreads in China which are currently very tight.
“But there are times when spreads have been wider and it’s right opportunistically to take that credit risk,” he says.
Because there is no Bankruptcy Code in China, Amstad says Aberdeen’s view is to take Chinese credit risk through offshore US-dollar bond markets, as the spreads are not only much wide but documentation is much better.
“That way, if something goes wrong, you end up in a courtroom in New York or London, rather than in Shanghai,” he says.
Ultimately, Chinese government bonds offer a good diversifier as the Chinese and US interest rate cycles don’t always coincide.
Benjamin Fanger, managing partner and founder at ShoreVest Partners suggests China and the US’s stimulus approaches during the pandemic have reversed following their handling of the Global Financial Crisis in 2009.
“After the GFC, China basically called up the banks and told them to lend to every company that walks in the door, whether or not they have a pulse, so we saw the biggest credit boom in the history of the world,” Fanger says.
At the same time, the US “tore the band-aid off” and created an opportunity for distressed and direct lending.
“Post-pandemic, China’s following that approach now, where they’re refusing to flood the market with cash whereas the US is happy to,” Fanger says.
Zooming in from the macro perspective to the micro-business level perspective, Fanger says the opportunity to buy bad debt from Chinese banks at a significant discount still remains.
“We’ve been doing that for a decade, so it was an opportunity before the pandemic,” he says.
But post-pandemic ShoreVest has found asset-backed lending has a place with Chinese corporates looking for capital after the regulatory pullback that saw limits on the shadow banking system and retail investors leave the market.
“That left a vacuum of capital for companies that resulted in a cost of capital they’re willing to pay for as direct lending goes up,” Fanger says.
Direct lending to corporates, through bilateral negotiated deals or loans purchased from banks, is a lot safer than invested in bonds in high yield markets, Fanger says.
“This private debt, things like senior secured real estate backed debt, means we can enforce on it and there’s a margin of safety,” he says.
The bond market, on the other hand, has a risk that the Chinese government will step in.
That said, Fanger recalls an event a decade ago where the Chinese actively let a government-owned entity fail.
“That was a very sad ending for a lot of foreign investors, so it’s been made clear that government intervention is not always guaranteed,” he says.