Goldman: $1 trillion opportunity in Chinese bonds

Published Tue, Sep 22 20155:31 PM EDT

Evelyn Cheng @in/evelyn-cheng-53b23624 @chengevelyn

As China's stock market collapses, Goldman Sachs sees a new investment opportunity in that country: the domestic bond market. "We expect more channels to be introduced, with significant potential to draw in foreign investment. Should foreign participation catch up to roughly the level of, say, Japan and Australia, the equivalent of around 10 to 20 percent of GDP, that could translate into more than $1 trillion of additional global fixed income investments to be allocated to China domestic bonds in the coming years," analysts Kenneth Ho and MK Tang said in a Tuesday note. They expect China's bond market, the third largest in the world behind the U.S. and Japan, to more than triple in value from $6.3 trillion to $21.6 trillion in the next decade. Read More Global slowdown fear accelerates; How to trade it As of June 2015, foreign holdings of China domestic bonds totaled just $115 billion, or about 1.9 percent of the market, the note said. Commercial banks own 62 percent of the bonds, while state-related issuers account for 94 percent of total bonds outstanding, the note said. For China, generating that foreign investment after its bungled handling of the stock market could help smooth the economic transition and calm growth fears that have rattled global markets. Many analysts say the key benefit from more foreign investment in China is efficient allocation of resources. Read More China's real mission in the US this week "The way the market works is very chaotic and poor," said Arthur Kroeber, head of research at Gavekal Dragonomics. One school of thought is that "the way you improve the quality of the institutions is by bringing foreigners in, improving policies and norms." Attracting and retaining those investors is the challenge. The stock market bubble, shock currency move and heavy-handed government intervention throughout adds uncertainty to leadership's ability to master the opening of capital markets. Yuan-denominated Chinese bonds could now be the way in for investors looking to diversify. Relatively high yields of 3 to 4 percent on Chinese government debt offers better return than the volatile stock market many have termed a "casino." Beijing "still has high relative credibility if the RMB is stable," said Michael Pettis, finance professor at Peking University. "The real potential for foreign capital coming into the country is buying foreign government bonds. The only argument against that is depreciation of yuan." Chia Woon Khien, Nikko Asset Management's senior portfolio manager of fixed income, said her positions of about 312 million yuan ($48.9 million) in Chinese bonds were hurt by the currency devaluation. Now she's reducing credit risk exposure. "I do worry. In the last three months my concern has gone up a little bit more," she said. "There is always an issue but it hasn't reached the point where this market is such bad regulatory risk that I have to get out." Most on Wall Street don't expect a major drop in the yuan's value. UBS Wealth Management estimates China's currency could see moderate depreciation by about 3 to 4 percent in the next 12 months, or about 6.6 against the dollar. Stabilization in the yuan and increased global recognition, such as inclusion in the IMF's SDR basket, could help generate more purchases of yuan-denominated assets. "We expect further financial reforms to help drive the bond market to become the next financing engine," the Goldman report said. "We believe that the bond market will become one of the most important capital markets for domestic investors and also a market with rising importance for international investors." With an established bond market, China could move toward building financing structures needed to become like other developed, consumer-driven economies. Read More Hank Paulson: China economy has 'run out of steam' "They want to create a modern investment market that supports consumption," said Clem Miller, portfolio manager at Wilmington Trust Investment Advisors.

The Goldman Sachs booth on the floor of the New York Stock Exchange

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As China's stock market collapses, Goldman Sachs sees a new investment opportunity in that country: the domestic bond market.

"We expect more channels to be introduced, with significant potential to draw in foreign investment. Should foreign participation catch up to roughly the level of, say, Japan and Australia, the equivalent of around 10 to 20 percent of GDP, that could translate into more than $1 trillion of additional global fixed income investments to be allocated to China domestic bonds in the coming years," analysts Kenneth Ho and MK Tang said in a Tuesday note.

They expect China's bond market, the third largest in the world behind the U.S. and Japan, to more than triple in value from $6.3 trillion to $21.6 trillion in the next decade.