Growth in China’s offshore corporate bond market seems likely to continue in 2018, driven by the financing needs of investment grade state-owned enterprises (SOEs) and private sector companies. This market has exhibited extraordinary resilience and strong performance over the last 12 months due to a variety of technical and macroeconomic factors, helping China become the leading issuer of emerging market debt and a growing presence in global credit indexes. Here are five bottom-up themes we expect will continue to drive China's U.S. dollar-denominated corporate bonds issued in the offshore market in the coming year.
- Multi-year capacity consolidation and property inventory destocking. China’s industrial capacity utilization ratio rebounded to a two-year high of 76% in Q3 2017 due to a number of factors such as supply side reforms, higher export demand and improved domestic demand. We expect this capacity improvement to continue despite a cooling in China’s housing market. Residential property inventory is at multi-year lows across Tier 1, 2 and select Tier 3 cities due to strong demand; however, average home price
appreciation has moderated as local government restrictions aimed at reducing speculation have begun to kick in. While we are likely to see a continued cooling in property prices and sales over the coming year, we think a crash is unlikely because inventory is tight.
- Corporate pricing power. A rise in core inflation and non-commodity producer price inflation suggests that manufacturers have increasingly been able to pass higher costs on to customers. The price of refrigerators, air conditioners, washing machines and other household appliances, for example, rose about 10% last year, according to China Market Monitor. This reflects the recent spike in ferrous metal prices, their key input.
- Non-commodity sector reflation. Better corporate pricing power has led non-commodity sectors, such as electronics, technology, machinery, health care and housing to emerge as key drivers of industrial revenue and profit growth.
- Differentiated capex growth. While we expect fixed asset investment growth to moderate in 2018, stronger growth in private sector capital expenditures (capex) – especially in manufacturing – is likely to partially offset weaker growth in SOE investment. The key driver of capex in this cycle has been equipment upgrades for existing plants and machinery, rather than spending on greenfield projects. In theory, this will improve productivity, but more so in the private sector. Large and mid-sized private property developers have pursued aggressive debt-funded land bank development since 2016, but capex may moderate in 2018.
- Diverging credit fundamentals. Credit metrics for investment grade companies have improved on better EBITDA (earnings before interest, tax, depreciation and amortization) margins, while debt levels have remained flat due to slower mergers and acquisitions (M&A) and capex growth. High yield corporate credit metrics have
stabilized somewhat since 2016 as EBITDA has recovered in key property, commodity and industrial companies. Defaults of U.S. dollar-denominated high yield corporate bonds issued in the offshore bond market have been largely idiosyncratic and remain low at around 2%. We expect benign default rates in the near term given the fundamental backdrop.
The continued reflation of the non-commodity sectors in China implies top line and earnings growth will continue into 2018, albeit at a slower pace. Fundamentally, we prefer high quality Chinese credits, especially in “policy” SOEs with strong state support, “commercial” SOEs with strong standalone fundamentals and private sector companies in China’s new economy. Even in these segments, we carefully consider relative value at different points on the yield curve given the outperformance of Chinese investment grade credits compared with developed market credits.