International investors are turning to Chinese government-linked corporate bonds in anticipation of strong demand for China's first US dollar sovereign bond since 2004. China has announced plans for a US $2bn offering before the end of the year, but the relatively small size of the deal means many are looking for more liquid ways to bet on a good result.
Five-year and 10-year bonds from China state-owned utilities and oil companies have been among the main beneficiaries so far, according to Jethro Goodchild, head of Asian credit at Aviva Investors. "[The potential sovereign issue] is creating a catalyst for further tightening in Asian credit spreads in the highly rated space, which has looked cheap on a global basis for some time," he said.
China's finance ministry said in June it planned to issue US $2bn of dollar-denominated sovereign bonds in the second half of this year, and expectations are centred around a 10-year offering. Chinese banks are expected to dominate demand for the bonds, potentially crowding out foreign investors and driving pricing tighter than the sovereign's rating would imply. "The current sentiment is that all Chinese banks will support the deal, which is why most people are expecting it to trade inside Korea when it's first issued," said Edmund Goh, investment manager, Asia fixed income, at Aberdeen Standard Investments. "That looks pretty probable, considering Korea has widened due to the North Korea situation."
South Korea is rated Aa2/AA/AA-, compared with A1/AA-/A+ for China, but recent tensions between the US and North Korea have unnerved investors. This year, Chinese sovereign five-year CDS has tightened more than 60bp as that for South Korea has widened 20bp, meaning that Chinese CDS now trades at 53bp mid, 12bp inside Korea, despite their ratings, according to Thomson Reuters data.
Korea's 2027 bonds were bid at a Treasury spread of 82bp on Wednesday, while Triple A rated Singapore state investment holding company Temasek Holdings had 2023 bonds, the closest it has to a 10-year dollar maturity, trading at Treasuries plus 52bp, according to Tradeweb. "When you have a very small inaugural deal with a lot of eyes on it, that probably won't leave much upside for investors," said Luke Spajic, head of portfolio management for emerging Asia at Pimco.
That has led some investors to look at dollar bonds issued by similar state-linked credits. Not only do Chinese banks and state-owned enterprises have a similar risk profile to the sovereign, but they are also expected to benefit as investors who are not allocated sovereign bonds pour their money into the closest comparable credits they can find.
"A lot of high-grade SOE bonds from China tightened because people believe they might not get enough sovereign bonds and the SOE spreads look attractive," said Leo Hu, senior portfolio manager, emerging markets debt, NN Investment Partners. The 3.625% April 2027 bonds of China Petrochemical Corp (Sinopec) were quoted at Treasuries plus 130bp on June 12, the day before China announced plans to sell offshore sovereign bonds, while State Grid Corp of China's 2027 bonds were at Treasuries plus 122bp. Both have tightened in anticipation of the new sovereign deal.
"China SOE bonds have reacted months ahead of this," said Aberdeen Standard's Goh. "Sinopec and State Grid are now at a spread of around 100bp, close to where Korean quasi-government names are trading, so there is limited room for them to move tighter. If you have been underweight investment-grade China credit you would have been quite badly impacted by secondary movements, but there is nothing you can do at this time if you missed the boat." Some investors, though, believe that setting a new sovereign benchmark could reprice some state-owned credits, leading them to tighten even further once the deal has priced.
"There is a widespread belief that there will be some compression of corporate spreads towards the sovereign after this deal," said Pimco's Spajic. Some believe that China should not be considered alongside other emerging markets sovereigns, giving its role in driving the global economy, which makes pricing references difficult.
"China is almost unique in terms of scale and trajectory," said Spajic. "It's almost impossible to find an emerging markets comparison. This is a country that will probably in a decade overtake the US in nominal GDP. Its currency has SDR (special drawing rights) status, and its GDP has an enormous impact on the global economy. "The only other country that might follow a similar growth path is India, and we have been trying to convince them to issue a sovereign bond for years."
Fund managers are divided on whether this will be a one-off issue, perhaps intended to be a defiant response to Moody's decision to downgrade China to A1 from Aa3 in May this year, or whether it could be the start of regular visits to the dollar market. "The background is symbolic for the China government," said NNIP's Hu. "They have US $3trn in foreign reserves, so it's not because they need the money. Chinese equities have been added to the MSCI index and they have launched Bond Connect. The next step is for them to have a sovereign bond issue."
China last issued dollars in 2004 and has never been a regular issuer. It already has a US $100m October 2027 bond that yields around Z plus 100bp and is rarely traded, even though in theory it offers better value than the new issue probably will.
That is expected to lead to a rush for the new issue, and US $2bn of paper is unlikely to be anywhere near enough to fill everyone's order. "Investors would be naive to think this is the only deal and they'll never issue again. We expect them to build out a curve over time," said Pimco's Spajic. "It wouldn't be very costly to do so, and it would be easy for them to do that."
The relatively modest expected size and limited tenor of the new issue might be a disappointment to some, especially since China issued a century bond in 1996, but the sovereign can easily fund itself in the domestic market. "It would be natural for them to extend the curve and issue much further out, but it's not as if there's much urgency for them to do this," said Spajic. "It's almost like they're doing this issue as a favour to the international capital markets."
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