China's bond market will double in size from the current $9 trillion over the next five years, overtaking Japan's to become the world's second largest behind the United States', UBS Asset Management said in a report.
Underpinning that growth is a law passed in 2015 to prohibit local provinces and cities from borrowing from banks. Instead, they were required to borrow in the public debt markets as Chinese authorities sought to transfer some risks away from banks.
"We believe more and more Chinese entities will raise capital in the onshore bond market, given that the domestic market is already large and liquid enough to attract new investors," the Swiss fund house wrote in its report.
It predicted that China's local government bond market will grow to more than $3 trillion in the next three years from the current $1 trillion — just about on par with U.S. municipal debt size of $3.8 trillion.
Such growth prospects, coupled with the country's financial reforms, make China's debt market an attractive investment, UBS said. Those with higher credit risk may select state-owned enterprises, local government bonds or issuance by the five largest banks, it added.
"In the aftermath of the global financial crisis, unorthodox monetary policy led to asset price inflation in all traditional asset classes. This in turn has created yield compression, with the amount of negative-yielding sovereign debt globally estimated at $8.6 trillion, according to Fitch Ratings (March 2017)," according to the UBS report.
Chinese bonds, on the other hand, offer "attractive yields" on both a nominal and real basis, UBS said, adding that "there remains the potential for capital gains should bond yields move lower from their current levels." The fund house also noted Chinese bonds' "defensive characteristics" (investment grade and a from net creditor country) which make them "attractive in a portfolio context."
China's rising debt and moderating growth have often been cited as a key risk to global markets as the country's economic influence widens. Moody's last month downgraded the country's rating from A1 to Aa3 and flagged that its economy-wide debt levels were expected to increase further in the years ahead. Reforms were only likely to slow China's growth rate, the agency said.
Yet while UBS may see opportunity in the bond market, China's own government bonds may be signalling problems with the wider economy.
In a note this week, PIMCO's emerging markets portfolio manager Isaac Meng noted that the 10-year Chinese government bond yield sank below the one-year yield — which happened only once before, on June 2013, amid "a severe liquidity crunch in the interbank market."
"The [People's Bank of China] has clearly tightened monetary conditions, pressuring banks to curb corporate and mortgage lending while passing through higher lending rates to borrowers… On the margin, China's monetary tightening and financial deleveraging will be a headwind to a rebound in global manufacturing and reflation in commodities," Meng wrote.
"A persistent wholesale funding squeeze and yield-curve inversion in a relatively opaque and interconnected financial system are signals of strain; they should be taken seriously by both policymakers and investors."