A brief introduction to China’s bond market

• China’s bond market is ranked third globally in terms of size, occupying about 95% of GDP. With rapid economic growth, stable financial conditions, and government support in its developing capital market, China’s bond market is growing quickly in terms of both issuance and trading volume, with increasingly diversified bond varieties, issuers, and investors. Bond issuance is now the main channel of direct financing for corporates in China.
• Market fragmentation is one of the features of China’s bond market. China’s bond market is dominated by the interbank bond market (OTC market) and supplemented by the exchange bond market. Due to lack of connectivity, sub-markets are discrete, with different trading systems, market participants, and bond varieties. Accordingly, the regulatory framework is also fragmented. This is reflected in multiple systems of regulation with different regulatory concepts, operation mechanisms, and regulatory styles on different trading floors by different regulators.
• Governmental institutions are the main issuers and commercial banks are the main holders. As for outstanding bonds, China's bond market is dominated by bonds issued by governmental institutions-about 57% of the total, but the share of credit bonds issued by commercial financial institutions and non-financial corporates is increasing. As for investor structure, the market is commercial bank-dominated. This is one of the main reasons for the insufficient liquidity of the secondary market, as commercial banks are prone to holding bonds to maturity.
• The volume of bond issuance in the primary market is growing rapidly, yet with structural divergence. Bond issuance has tended to concentrate on highly-rated and short-term maturities in recent years. As for repayment schedules, about 25% of debt on bonds is going to be repaid within one year, and more than half of debt will be repaid in the next three years.
• Initial credit ratings of bonds and issuers are generally between AAA and AA on the national scale, being assigned by domestic rating agencies and subject to regulation and issuance constraints. Compared with the international scale assigned by international rating agencies, ratings on the national scale are normally 5 sub-notches higher due to restrictions set by the country ceiling and different adopted benchmarks.
• The opening-up of China’s bond market is accelerating. Comparably, the opening-up of the issuance side started earlier with the emergence of the panda bond market, but the level of opening-up on the investment side is higher. However, foreign investors only account for 2.3% of the market and mainly invest in Treasury bonds with low risk appetite.

A brief introduction to the history of China’s bond market

China's bond market was initiated when the issuance of Treasury bonds resumed in 1981. After 30 years of development, especially since 2015, with the promotion of market-based reform of interest rates, the construction of the bond market system, and the improvement of the regulation system, market participants and bond varieties have been increasingly diversified and both issuance and trading volumes have been growing rapidly. Since 2016, the size of China’s bond market has been ranked third globally, surpassed only by the US and Japan. At the end of 2018, the total volume of outstanding bonds in China’s bond market reached RMB 85.7 trln (about USD 12.5 trln¹), about 95.2% of China’s GDP. The bond market has been an important component in China’s financial market and the main channel of direct financing for corporates.

¹On December 28, 2018, the central parity rate of the RMB against the USD was 6.8632.

Figure 1. A sketch of China’s bond market development

Figure 2. Outstanding bonds, % of GDP (at the end of the year)

 ¹ On December 28, 2018, the central parity rate of the RMB against the USD was 6.8632

How China’s bond market is organized

OTC market – over-the-counter market for bonds.

China’s bond market is comprised by of an OTC market and exchange market. The OTC market includes an interbank market and commercial bank OTC market, and the exchange market consists of the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE). In 1997, the national interbank bond market was established and then developed rapidly. In 2001, the volume of bond issuance, trading, and custody in the interbank bond market surpassed that of the exchange bond market. Since then, China has formed a bond market system which is dominated by the interbank market and supplemented by the exchange and commercial bank OTC markets.

Figure 3. The framework of the bond market

Source: Golden Credit

The interbank bond market is a bulk trading market (wholesale market) for institutional investors. The participation of commercial banks makes it the main body of China's bond market. At the end of 2018, outstanding bonds in the interbank market accounted for 51.3% of the total. The exchange market is not only a retail market that carries out centralized matchmaking, but also a wholesale market composed of a fixed income platform and a bulk trading system. As only publicly listed commercial banks are allowed access to the exchange market² and some types of bonds can only be traded in the interbank bond market, both the issuance and trading volumes of the interbank market are larger than those of the exchange market. The commercial bank OTC market is a very small retail market for Treasury bonds and local government bonds.

² In 1997, commercial banks were required by the People’s Bank of China to withdraw fr om the exchange bond market and therefore could only participate in the interbank bond market. In 2010, publicly listed commercial banks were allowed to return to the exchange bond market to conduct trading and repo of cash bonds.

Certain types of bonds, such as Treasury bonds, can be traded in two or three sub-markets via custody transfer

Figure 4. Proportion of outstanding bonds of different sub-markets as of December 31, 2018

Source: WIND, Golden Credit

Figure 5. Comparison of the volumes of bond issuance and trading in the interbank market and the exchange market, RMB bln

Source: WIND, Golden Credit
Due to the lack of effective connectivity, China’s bond market is characterized by market fragmentation. The interbank bond market and the exchange bond market are discrete, with different trading mechanisms, market participants, and bond varieties. They are also regulated separately, with different institutions responsible for registration, custody, and settlement. Market fragmentation results in low liquidity and decentralized trading, and encumbers market depth and efficiency. In this context, regulators have taken measures to promote bond market connectivity in recent years. In 2013, the People’s Bank of China (PBoC) and China Securities Regulatory Commission (CSRC) approved China Development Bank to issue policy bank bonds in the exchange bond market. Before that, policy bank bonds could only be issued in the interbank bond market. In September 2018, PBoC and CSRC announced the promotion of the gradual unification of rating qualifications in different markets. In December 2018, PBoC, CSRS and the National Development and Reform Commission confirmed that CSRC is responsible for the unified law enforcement against illegal acts in both the interbank bond market and exchange bond market. These policies show that China's bond market has been progressing toward connectivity and unification. It is expected that regulators will continue to adjust policies to promote the connectivity of market participants, bond varieties, as well as the systems of settlement and custody of different sub-markets, and ultimately establish a bond market under unified regulation for coordinated development.

The structure of issuers and investors in China’s bond market

Issuers in China’s bond market include governments and governmental institutions, as well as financial institutions and non-financial corporates. For bond varieties classified by different issuers, see Table 1. As for bond varieties classified by payment modes, there are zero coupon bonds, discounted bonds, fixed interest rate bonds, floating interest rate bonds, and lump-sum cleared bonds. To satisfy diversified financing demands, many innovative types of bonds have been issued in recent years, such as green bonds, Belt and Road bonds, as well as innovative and entrepreneurial corporate bonds. Green bonds were initially issued in China in 2016 and the issuance volume that year by Chinese issuers both at home and abroad reached RMB 238 bln (about USD 35.8 bln), ranking first in the world.

Table 1. Bond varieties in China’s bond market classified by issuers

At the end of 2018, government bonds accounted for 40.4% of total outstanding bonds, among which 17.4% were Treasury bonds and 21.1% were local government bonds. Meanwhile, the outstanding amounts of corporate credit bonds and financial bonds accounted for 20.9% and 23.7% respectively.

Table 2. Composition of outstanding bonds at the end of 2018

Source: WIND, Golden Credit

Rate securities in China’s bond market are bonds issued by governments and governmental institutions, including Treasury bonds, local government bonds, central bank bills, policy bank bonds, and government-backed agency bonds.

In this report, credit bonds are financial bonds minus policy bank bonds, plus corporate credit bonds. There are different ways to define credit bonds. According to some research, the term credit bond refers to only corporate credit bonds issued by non-financial corporates.​

If differentiated by rate securities and credit bonds, the outstanding amount of rate securities accounted for 57.1% at the end of 2018; that of credit bonds accounted for 27.8%. Therefore, China's bond market is still dominated by rate securities at present. However, with the continuous innovation of credit bond varieties and the relaxation of restrictions on issuers, the share of rate securities is declining.

Figure 6.  Share of rate securities to the outstanding bonds (at the end of the year)

Source: WIND, Golden Credit

To read more about QFII/RQFII, see page 28.

In recent years, the number and types of investors in China’s bond market have been expanding, and the structure of investors tends to improve. But by far, commercial banks still dominate the market.

Investors in the interbank bond market: qualified non-bank financial institutions and non-financial enterprises, commercial banks, policy banks, and QFII/RQFII with the approval of the People’s Bank of China for interbank access. < >Investors in the exchange bond market: non-bank financial institutions, non-financial enterprises, listed commercial banks, QFII/RQFII with the approval of the People’s Bank of China for interbank access, and individual investors.

“Unincorporated products” include securities investment funds, national social security funds, trust plans, enterprise annuity funds, insurance products, asset management plans of securities companies, specific asset management portfolios of fund companies, commercial products of commercial banks, etc.

Figure 7. Structure of investors at the end of 2018

Source: WIND, Golden Credit

As for the structure of investors, China’s bond market is bank-dominated as the banking sector being the main body of China’s financial system. At the end of 2018, the outstanding bonds held by commercial banks accounted for 55.5% of the total outstanding bonds in China’s bond market. This is an important reason for the low liquidity of the secondary market as commercial banks are more willing to hold bonds to maturity, and also, to some extent, hinders the transfer of risks from the banking sector to other sectors. However, with the gradual opening-up of the bond market and the entry of other types of investors, the proportion of bonds held by commercial banks has showed a tendency to decline. Currently, funds which tend to trade in the market more actively than other investors have become the largest holder of credit bonds.

How China’s bond is market regulated

The regulatory framework of China’s bond market is also fragmented. China’s bond market has been developing from government planned to market-oriented and from unorganized to well-regulated. Throughout this process, the government has undertaken the role of coordinating interests and establishing fundamental systems. The emergence of different bond markets and bond varieties were promoted by different government departments and this led to a fragmented regulatory framework.

Table 3. The regulatory system of China’s bond market

NAFMII- National Association of Financial Market Institutional Investors，CSRS- China Securities Regulatory Commission，NDRC- National Development and Reform Commission

Table 4. Issuance regulation of main varieties of corporate credit bonds

Source: Golden Credit

DVP - Delivery Versus Payment.

Regulation of trading floors: The regulators of the interbank bond market and the exchange bond market are the People's Bank of China and the China Securities Regulatory Commission, respectively. Both markets have set specific requirements on information disclosure in terms of disclosure time, disclosure of major events, and so on. The information disclosure on enterprise bonds is regulated by the National Development and Reform Commission.

Regulation of clearing, settlement, and custody: There are three custody institutions that are regulated by different regulators. The opening of securities accounts for investors in the interbank bond market is in China Central Depository & Clearing Corporation Limited or Shanghai Clearing House, while China Securities Depository and Clearing Corporation Limited is responsible for the custody and settlement in the exchange bond market. The clearing and settlement mechanism applied in the interbank market includes full bilateral clearing and net amount centralized clearing. The former usually adopts the settlement method of DVP while the latter usually adopts “central counter party.”

Regulation of rating agencies: The regulation of rating agencies is fragmented as well, which to some extent leads to the inconsistency of rating standards in different sub-markets. In September 2018, the People's Bank of China and the China Securities Regulatory Commission announced the promotion of the gradual unification of rating qualifications in different markets in order to promote the unified regulation of the credit rating industry. Together with the National Association of Securities Dealers, they will form a “concerted action person” to regulate rating agencies, showing that China’s credit rating industry has formally entered the era of unified regulation.

The regulatory framework of China’s bond market together with related systems has played a positive role in preventing market risk and boosting market development. But the existing regulatory system also has limitations mainly reflected by the lack of a unified legal system as well as by the existence of multiple regulatory systems with different morals, operation mechanisms, and styles of regulation in different trading floors with different regulators. This hinders the efficient allocation of financial resources, the unified prevention and control of risks, and the opening-up of the bond market. In this context, China’s bond market will tend to be regulated in a unified way step-by-step, and recent policies have confirmed these tendencies.

What’s going on in the primary market?

• The volume of bond issuance in the primary market is growing rapidly, and the share of credit bonds⁴  is increasing.

China’s primary bond market is wh ere issuers obtain direct financing by issuing bonds. With the exception of 2008 and 2011, when the issuance volume grew negatively due to the effects of the financial crisis and tightened monetary policy, respectively, the issuance volume in China’s bond market in the past decade has been on the rise, from RMB 5.9 trln in 2006 to RMB 43. 8 trln in 2018.

The rapid growth of the issuance volume of interbank negotiable certificates of deposits is difficult to sustain because of the financial deleveraging and tightened supervision of interbank business.

In terms of issuance structure, the issuance volume of rate securities⁵  remains relatively stable and the proportion of the issuance volume of credit bonds has been increasing. Meanwhile, the issuance of interbank negotiable certificates of deposits, a main source of funds for the off-balance-sheet activities⁶  of banks, has expanded rapidly in recent years. In 2018, the total issuance volume of bonds in China’s bond market was RMB 43.8 trln, of which 26.3% were rate securities, 20.6% were credit bonds, and 48.1% were interbank negotiable certificates of deposits.  

Figure 8. Bond issuance in China’s bond market, RMB bln

Source: WIND, Golden Credit

The issuance volume of rate securities has fluctuated somewhat in the past decade. As the issuance of central bank bills stopped in 2013, the issuance volume of rate securities was at its lowest point in the decade in 2014. Then, with the promotion of China's local government bond reforms (in May 2014, the Ministry of Finance published the ‘Trial Measures on the Self-issuance and Self-payment of Local Government Bonds’), the issuance of local government bonds increased substantially after 2015 and consequently drove up the issuance volume of rate securities.

Over the past decade, the issuance volume of credit bonds has generally shown trends of growth. In 2017, due to the tightening of monetary policy and financial deleveraging, the issuance volume of credit bonds declined. In 2018, with the marginal easing of monetary policy, the liquidity of the money market remained reasonably abundant, and the issuance volume of credit bonds rebounded.

⁴ See page 6 for the definition of credit bonds.
⁵ See page 6 for the definition of rate securities.
⁶ Off-balance-sheet activities are the businesses of commercial banks that are not included on the balance sheets but are included in the profits and losses of the current period.

Figure 9. Issuance of rate securities (left) and credit bonds (right), RMB bln

• Bond issuance tends to concentrate on highly-rated and short-term maturities.

The issuance volume of rated bonds increased from 0.6 trln in 2007 to 30.5 trln in 2018 and its share in total bond issuance is increasingly higher, indicating that the coverage ratio of credit ratings has risen year by year. Due to regulatory and issuance limitations, the credit ratings of issued bonds are mainly between AAA and AA.

Over the past decade, the proportion of the issuance volume of bonds with high credit ratings has continued to increase. After the first bond default in 2014, the exposure of credit risk and frequent occurrence of defaults has led to a downturn of investors’ risk appetite. In recent years, the proportion of the issuance volume of issuers with a rating of AAA has increased significantly, while that of the low-rated issuers has declined.

Figure 10. Proportion of bonds issued by issuers with different credit ratings⁷

⁷ For all bond varieties in China's bond market.

As for term structure, bond maturities have shown the tendency to shorten over the past decade. The proportion of bonds issued with a maturity of within 1 year (including 1 year) was 17.6% in 2007 and climbed to 60.8% in 2018. At the same time, the proportion of bonds issued with a maturity above 5 years declined from 59.8% in 2007 to12.8% in 2018.

For issuers, their willingness to make long-term investment declines with the slowdown of China's economic growth, so the issuance of short-term bonds is more suitable for issuers’ needs. Investors are more inclined to hold short-term bonds due to the gradual exposure of credit risk. Since 2015, the issuance of interbank negotiable certificates of deposits, the maturity of which generally being within one year, has also aggravated the shortening trend of bond issuance.

Figure 11. Issuance volume of bonds with different maturities, RMB bln

As for repayment schedules, almost one-fourth of debt on bonds is going to be repaid within one year, and more than half will be repaid in the next 3 years.

Figure 12. Debt repayment schedule (by option date), as of December 31, 2018

What’s going on in the secondary market?

• The trading volume of bonds has increased overall but fluctuates heavily, and the liquidity of the secondary market is low.

The trading volume of bonds in the secondary market is closely related to the volume of bond issuance and the market environment. In recent years, as the volume of bond issuance continues to increase, the trading volume of China’s bond market has shown an overall increase. However, the trading volume of bonds fluctuates heavily due to changes in market conditions such as interest rates and regulatory policies.

Figure 13. Trading volume of bonds, RMB bln

Policy bank bonds account for the largest proportion of the trading volume of rate securities, while the trading volume of local government bonds is relatively small and has shrunk year by year since 2016 due to intensified regulation. The trading of credit bonds is concentrated on highly-rated bonds, while the liquidity of low-rated bonds in the secondary market is insufficient.

Figure 14. Trading of rate securities (left) and credit bonds (right)⁸, RMB bln

⁸ See page 6 for the definition of rate securities and credit bonds.

Insufficient liquidity is one of the major problems faced by China’s bond market. There are three main reasons. Firstly, the commercial banks which dominate the market have low trading frequency resulting in a large amount of bonds being held for a long time without flowing into the secondary market for trading. Secondly, the first default in China’s bond market occurred in 2014, which means it is still difficult for investors to accurately price bonds through the default rate, causing them to buy and hold bonds as the underlying configuration instead of trading them in the secondary market. Thirdly, the market’s maker system in the interbank bond market is ineffective, and as a result, makers provide insufficient liquidity to the market.

Table 5. Turnover rate in China’s bond market in 2018

Source: WIND, Golden Credit

YTM – Yield to Maturity

• China’s rate securities market is attractive with relatively high yields.

In recent years, YTM on China's ten-year Treasury bonds has fluctuated around 3.5%. By comparison, YTM on US ten-year Treasury bonds has stabilized and has been around 1% to 3% since 2011. The Bank of Japan adopted negative interest rates in 2016, and thus Japan’s ten-year Treasury bond yield has reduced to the current level of 0%. The YTM on Treasury bonds of major European countries like Germany and the UK has also demonstrated the tendency to decline after the global financial crisis.

Since 2018, YTM on US ten-year Treasury bonds has continued to increase with rising interest rates, strong economic performance, and an increased supply of Treasury bonds. Meanwhile, the yield on China’s Treasury bonds has showed the tendency to fall due to the easing of monetary policy, and thus the spread between yields on China and US ten-year Treasury bonds has declined.

Figure 15. Comparison of YTM on 10-year Treasury bonds, %

Source: WIND, Golden Credit

The issuers of policy bank bonds are development financial institutions (China Development Bank - CDB) and policy banks (The Export-Import Bank of China and the Agricultural Development Bank of China). Policy bank bonds enjoy sovereign credit, but their yields are higher than those of Treasury bonds, mainly reflecting tax differences as the interest income of Treasury bonds is exempt from taxes.

 Table 6. Tax rate for investing in China’s bond market

Source: Summarized by Golden Credit

Securities investment funds and foreign investors are exempt from taxes when investing in policy bank bonds (see Table 7). It is difficult to use a single fixed tax rate to adjust the taxation difference between Treasury bonds and policy bank bonds because in different market conditions changes in investor structure and the position structure of different investors may lead to changes in the overall difference in taxation. In this case, an ‘implied tax rate’ is introduced (see Figure 16).

Table 7. Tax rate for securities investment funds and foreign investors investing in China’s bond market

Source: WIND, Golden Credit

• The yield on credit bonds generally fluctuates with the yield on rate securities, however the range of fluctuation is wider.

There is no unified yield curve in China's credit bond market. We chose the yields on medium-term notes (interbank market) and corporate bonds (exchange market) to conduct the analysis. The yields on medium-term notes and corporate bonds are highly overlapping, and generally follow the yields on Treasury bonds but with larger fluctuations. During certain periods, yields on credit bonds may go in the opposite direction of the yields on Treasury bonds due to factors like the sharp downward trend of market risk appetite.

Figure 17. Comparison of yields on credit bonds with yields on Treasury bonds, %

Source: WIND, Golden Credit

Assessing credit risk in China through credit ratings

Subject to regulation and issuance constraints, the initial credit ratings of bonds and issuers are generally between AAA and AA. On average in China, for the same pool of issuing entities, the credit ratings assigned by domestic rating agencies are 5 sub-notches higher than the ratings assigned by international agencies.

Table 8. Distribution of latest credit ratings of rated corporates as of December 31, 2018

Differences in the ratings between domestic and foreign rating agencies are due to the following:

Ø Restrictions set by sovereign “ceilings” in credit rating assignments: According to international common practice, corporate ratings should remain at or below the sovereign rating of their country of incorporation. Therefore, the fact that domestic and foreign rating agencies assign different sovereign ratings to China is an important factor underlying the differences between the credit ratings of Chinese corporates by domestic and foreign rating agencies.

Ø Different benchmarks for ratings: Another possible reason for the differences in credit ratings between domestic and foreign rating agencies is that they adopt different credit rating benchmarks. When assessing the credit risk of a corporate, domestic rating agencies assign a credit rating based on its rank among all corporates in that country, while international rating agencies try to assign a credit rating based on its rank among all corporates globally.

Ø Threshold requirements for issuing and investing in public offering bonds: The credit ratings of issuers in China’s bond market are mainly rated AA or above by domestic rating agencies, which is more concentrated than the scale of ratings assigned by international rating agencies. An important factor is that there are threshold requirements for issuing and investing in public offering bonds. For example, in January 2015, the China Securities Regulatory Commission released ‘Corporate Bond Issuance and Trading Management Rules,’ requesting that public offering corporate bonds should have AAA ratings. 

Assessing credit risk in China through credit bond spread

The spread of credit bonds is affected by market interest rates, market sentiment, default events, etc. Moreover, the short-term oversupply of certain types of bonds may also drive up the spread in the short term. For example, the large issuance of medium-term notes led to the significantly increased spread in 2009. Credit bond spread rose to record highs in 2012 driven by a combination of rising benchmark interest rates and the fear of potential defaults. In 2018, the increase in spread was mainly due to the frequent occurrence of defaults.

To adjust the taxation difference, credit bond spread is calculated by subtracting the yield on CDB bonds instead of Treasury bonds.

Figure 18. Yield spread between 3-year AAA medium-term notes and 3-year CDB bonds, BPs

The factors that affect the spreads of yields among different ratings are similar to those that affect the spreads between credit bonds and CDB bonds, and thus they tend to move in the same direction. In the first half of 2018, the spreads of yields among different ratings rose significantly. Credit spreads reflected the negative impact of credit risk events such as downgrades and defaults as they drove down the risk appetite of investors. The liquidity to low-rated bonds shrunk, generating higher liquidity premiums and therefore driving up the yields on low-rated bonds.

Figure 19. Yield spread between different ratings of 3-year medium-term notes, AA-AAA, BPs

Assessing credit risk in China through analysis on defaults

Since “11 Chaori bond” defaulted in March 2014, and was marked as the very first default incident, the number of China’s credit bond defaults has increased gradually with an increasing average defaulted value.

Figure 20. Number of defaults in China’s bond market

Source: WIND, Golden Credit

In 2018, the number of newly defaulted issuers and defaulted bonds reached 43 and 161, respectively, both hitting a record high. 2018 is regarded as the second 'wave of defaults' after 2016, however the main default triggers are different. In 2016, the main cause of defaults was the low-sentiment and over-capacity of some industries. In 2018, the main cause was the increased difficulties in refinancing faced by corporates due to strict financial regulation and deleveraging.

As of the end of 2018, 23 industries[1] had bond defaults in China's bond market, mainly in commercial trade, multiproduct companies, construction and decoration, mining, and iron & steel; and involving scattered industries and weak correlation among them. With different factors triggering defaults, the industries with frequent defaults were different in 2018 from those in 2016. With the changes in policies and economic conditions, the industries with frequent bond defaults have shifted from overcapacity industries to competitive industries.

Table 9. Distribution of industries of defaults, 2014-2018

Defaulted issuers are mainly private enterprises. The credit ratings of defaulted issuers are gradually expanding from the low-rated to the highly-rated.

Ø There are two main reasons. Firstly, private enterprises are at a disadvantage compared to state-owned enterprises in terms of financing channels and financing costs. When the financing environment deteriorates, the ability of private enterprises to obtain financing will be the first thing affected. Secondly, as the risk appetite of investors decreases and their demand for high risk bonds declines, they tend to invest in government-backed or highly-rated bonds.

 Figure 21. Number of newly defaulted enterprises of different types in 2018