Long-Term Risks In China’s Bond Market Should Not Be Ignored – Analysis

By Wei Hongxu*

According to the latest data, as of January 10 this year, the existing scale of China’s wealth management market was RMB 27.31 trillion, a decrease of 1.44% from the end of December last year. Although the scale of wealth management is still shrinking, the growth rate drop indicates that the wealth management redemption crisis is ebbing. That being said, it will take time for the bond market to recover. In the financial redemption issues, some long-term problems in the country’s bond market still need to be resolved urgently.

As the largest capital market in the country, the bond market ranks second in the world in terms of market size. As of the end of December 2022, its custody balance was RMB 144.8 trillion, an increase of RMB 11.3 trillion year-on-year, of which the inter-bank bond market custody balance was RMB 125.3 trillion, and the exchange market custody balance was RMB 19.5 trillion. However, compared with the stock market with a total market value of more than RMB 90 trillion, there is still a big gap in the degree of marketization. Because of historic reasons, market segmentation cannot be changed in the short term, while the interconnection of the bond market and the increase in the number of investors may not be of much temporary help in preventing bond risks

Looking at the causes of the bond market shock in November last year, unexpected changes in factors such as the macroeconomic environment, the tweak of China’s COVID-19 measures, and the marginal relaxation of real estate policies are the main reasons for the country’s bond market volatility. At the same time, in recent years, bond defaults mainly by real estate companies have increased, which has also led to differentiation in the market, resulting in credit contraction and differentiation. The correction in the bond market directly led to a large-scale retracement of the net value of asset management products such as wealth management and funds have triggered a large-scale redemption of related products. Under the pressure of financial redemption, the bond market fell into a negative feedback cycle of “net value decline → redemption → dumping of bonds → net value decline”, which led to the continuous adjustment of the bond market. This change means fewer investors and lower market liquidity, which may lead to a vicious cycle of reduced funds and lower prices. For China, this is the biggest hidden danger of bond market volatility to macroeconomic and financial stability. As it stands, the risk of this vicious circle is being alleviated with the stabilization of the bond market and the increase of overall liquidity. However, the stabilization of the market is mainly the result of the improvement of macroeconomic expectations and the injection of monetary policy liquidity. Some problems and hidden dangers that have plagued the development of the bond market for a long time have not been eliminated and resolved so far.

Due to the lack of risk hedging tools, it is difficult for market investors to hedge risks, and it is considerably hard for them to play the function of market value discovery, which is prone to sharp rises and falls. This is not only detrimental to market investors but also corporate financing in the bond market. The inability to hedge risks means that the market mostly adopts a “buy and hold” strategy. Not only is the trading volume inactive, but also a unilateral market is formed. Some of those who are in the institutions believe that, at present, firstly, the structure of investors in the current credit bond market is relatively monolithic and concentrated, and there may be certain hidden dangers. Another issue is that the capital investment style is too consistent, which will also lead to stratification in the credit bond market (funds being concentrated in some bonds), and some types of bonds cannot be fully priced through marketization. This is what institutions generally believe to be a structural weakness in the bond market.

The second problem is concerning the leverage in the bond market. Investors in the secondary bond market now generally adopt the method of repurchasing and leverage to earn the interest rate difference between short-term funds and long-term bonds in order to increase yield and maximize profits. The decline in short-term market interest rates in November last year led to a sharp rise in the leverage ratio of the bond market. After the Chinese central bank tightened short-term liquidity, this pushed the short-term market interest rate closer to the policy interest rate. This is also a factor for the sharp fluctuations in the bond market as market institutions generally ignore the risk prevention and control of interest rate policy changes.

Then there is the issue of bond defaults. Although the current state-owned enterprises and real estate enterprises have exceeded rigid redemption, which causes market investors to be more rational about credit bond investment, due to the increase in bond defaults last year, the credit contraction has intensified the differentiation within the bond market. At the same time, the aftermath and reorganization of defaulted bonds have been unable to advance, making it difficult to clear the market, resulting in market investors being more willing to avoid risks and becoming less confident. Once there are rumors of the burble busting, there will be panic behavior that individual bonds, even industry bonds to being sold off. Some low-credit bonds had to be canceled the issuance because fewer people are interested in them, while others were blindly chased by investors, showing a structural bubble tendency.

Driven by policy and economic recovery, the bond market is stabilizing. However, long-standing problems may continue to affect the stability and healthy development of the bond market in the view of researchers at ANBOUND. In particular, under the influence of policy and economic fundamentals, if there is an interest rate adjustment, or even the possibility of a rate hike in the future, the Chinese bond market, which has long been accustomed to a loose environment, will inevitably fall into greater volatility. Therefore, the establishment and promotion of market risk-hedging products and mechanism construction should be a foremost priority. In addition, the constraint mechanism of repurchase transactions is also an important aspect, and it is necessary to avoid the speculative behavior of blindly increasing leverage. Although China’s real estate policy has been reversed in the new year, the market recovery remains slow, and the resulting risk of urban investment bond default has become one of the risks that market investors are concerned about. Once there is an urban investment bond default, the shattering of confidence in urban investment is bound to have a greater impact on the bond market. In this regard, the establishment of a bond default disposal mechanism and its advancement should be issues that have to be paid attention to in the construction of the bond market.

Final analysis conclusion:

Since the start of the new year, the Chinese economy and policies are improving, and the country’s bond market gradually stabilizes and begins to recover, which will bring less pressure on the redemption of wealth management and funds and avoid systemic risks caused by vicious circles. However, some internal factors exposed in the fluctuations of the bond market have not disappeared because of this and still pose hidden dangers to the stability and long-term development of the bond market in the future. These risks should not be ignored as the market stabilizes, and it is still necessary for China to speed up the reform process to resolve them.

Wei Hongxu is a researcher at ANBOUND