By Fran Rodilosso, head of fixed income ETF portfolio management at VanEck.

Fran Rodilosso, head of fixed income ETF portfolio management at VanEck.

International bond investors will soon need to consider a greater role for Chinese debt in their portfolios as the country’s bonds are likely to enter emerging markets and global bond indices in the near to medium term.

While the sheer size of the market and the well-advertised degree of leverage in the Chinese economy have led to concerns, the market and the Chinese government have begun to behave in a more market-oriented fashion. As yields and spreads adjust higher, investors may begin to see opportunities in the world’s third largest domestic debt market.

In fact, last year, a stronger yuan – even if boosted in part by restrictions on capital outflows – and higher yields helped attract foreign capital to the onshore market. Total offshore holdings in the interbank market reached 1.15 trillion yuan ($177 billion) by year end. Government yields rose even as the People’s Bank of China expanded liquidity in 2017, and credit spreads also moved wider.

Source: Bloomberg. Data as of 29 December 2017. Spread represents the difference between the ChinaBond Corporate Bond Yield Curve (AAA) 5Y or ChinaBond Corporate Bond Yield Curve (AA) 5Y and the ChinaBond Government Bond Yield Curve 5Y.

Wider spread levels represent a cheapening of asset prices as deleveraging continues, particularly in less efficient sectors dominated by state-owned enterprises. Although these conditions – tightening of credit and possibly higher default rates – present a difficult environment for investors in the near term, they also represent the continuation of much needed market reform.

The recent, although isolated, case of Dongbei Special Steel Group Co. Ltd, a state-owned steel producer that went bankrupt in 2016, provides a good example of the central government’s increasingly differentiated support for state-owned enterprises. Holders of its defaulted bonds agreed to a deep discount to par with an option to swap the restructured debt to equity. In addition, private capital was accessed from a strategic investor, who took a controlling stake in the company.

Market-based solutions to inefficiency, excess capacity and excess leverage, as well as an improved pricing mechanism that better reflects risk, should ultimately provide confidence to foreign investors, who continue to have very low exposure in the domestic market.

In order to assert a more permanent position in international bond portfolios investors will require additional confidence that recent policies to open up the market in China will not be reversed in times of market stress. One result of convincing the market of the permanence of reforms will be the inclusion of onshore bonds in global fixed income benchmarks, likely leading to significant inflows into the domestic market.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)