Ballooning Chinese dollar borrowing a dilemma for index trackers

Record-breaking dollar bond sales from Chinese companies are steadily increasing China’s weight in global indexes, raising concerns about overexposure among investors who track them.

Corporates’ rapid move onto offshore bond markets, partly a response to the crackdown on runaway credit growth at home, highlights China’s multi-faceted indebtedness, a growing worry for investors.

Overall debt is approaching 300 percent of annual economic output (GDP) and Moody’s said it was the reason for cutting China’s credit rating for the first time in 30 years.

Stripping out maturing debt and coupon payments, year-to-date bond sales from companies in emerging markets total $65 billion including $54 billion from China, JPMorgan estimates. In gross issuance terms, almost half this year’s emerging market corporate bond sales are from Chinese firms, the bank said.

Company debt issuance in other emerging markets has been subdued by commodity and growth slumps. Some indexes cap the weight they give to each country but most are committed to broadly representing the market.

This means that the indexes have to increase the weighting they give to China and investors whose portfolios track or benchmark an index must adjust accordingly.

“It poses a challenge for global portfolios. You don’t want to have too much of a good thing,” said Greg Saichin, head of emerging debt at AllianzGlobal Investments.

China today comprises around 20 percent of the Markit iBOXX emerging market corporate index versus 0.5 percent in 2007.

In JPMorgan’s CEMBI Broad index too, China is 21 percent, up from less than 4 percent in 2010, though in the iBoxx corporate dollar bond index which also includes developed countries and is dominated by U.S. names, China’s weight remains around 0.8 percent. It has risen however from 0.074 percent five years ago.

Chinese firms should this year easily surpass the $108 billion debt raised in 2016 and $116 billion in 2014. In 2010, just $14 billion was issued.

“It’s just a juggernaut of issuance,” said Guy Stear, co-head of fixed income research at Societe Generale in Paris. “It’s so large that it’s a game changer in terms of EM corporates… it’s not just commodity companies, its cement, materials, internet companies, there’s a broad range.”

The Chinese deals are mostly welcomed by money managers who need to invest the money pouring into their funds. Also, Chinese state-run firms still carry investment grade ratings, unlike issuers from many big emerging economies such as Russia, Turkey, and Brazil.

“Relative to rating Chinese debt pays relatively decent yield…against that people are conscious that if you are running an EM credit fund you have very very high exposure to one part of the world,” Stear said.

Allocation conundrum

One popular solution for the allocation dilemma is “unconstrained” debt funds that are less committed to representing the market.

Morningstar data showed 10 such funds focused on Asian fixed income were launched already this year by asset managers. More than 40 launched in 2016.

“We are already seeing clients and investors wanting a diversified approach rather than just seeking exposure to a broad emerging market bond index,” said Bryan Collins, a portfolio manager at Fidelity International in Hong Kong.

Such funds can opt for less China exposure. Or they can delve down the credit curve and away from state-run firms whose close correlation with sovereign yields offers less prospect of outperformance, Collins said.

Other commonly used indexes cap China’s weight – JPMorgan’s CEMBI Broad Diversified limits the weight each country can have, while Citigroup and Bloomberg have recently launched index variations capping China exposure.

“We stay with the Broad Diversified and we are comfortable with China at 8-10 percent,” said Steve Cook, co-head of emerging debt at PineBridge Investments in London.

Cook noted that the $400 billion-plus market was still a fraction of the $5.7 trillion outstanding in U.S. investment grade credit. Corporate dollar bonds also comprise a small proportion of the country’s overall debt, estimated by some to be as high as $28 trillion.

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Chinese authorities were trying to cool the dollar bond boom even before the Moody’s rating downgrade. Property firms for instance no longer receive new issuance quotas, Reuters has reported.

Their efforts could accelerate after the Moody’s downgrade and subsequent rating cuts for state-run firms should also raise borrowing costs.

But bond sales are unlikely to grind to a complete halt. For one, raising cash overseas can allow companies to sidestep curbs that are in place to combat capital flight.

Second, companies’ total debt repayments in 2017 are estimated at 5.5 trillion yuan ($797.36 billion) by ratings agency China Chengxin. For investment-grade Chinese firms, dollar borrowing works out some 90 basis points cheaper than on domestic markets where interest rates have risen.

The spread between JP Morgan’s China index and onshore AA-rated corporate debt is at its widest in two years, this chart shows: tmsnrt.rs/2rxmkUI

“If you are laden with debt, interest rates are rising and you need to roll over debt, you find the money wherever you can,” Stephen Jen, CEO of Eurizon SLJ Capital, said.