Friday, July 1

Navigating the Chinese ESG Bond Market

Broadly speaking, there are two types of risks to consider: those related to politics and those related to the market.

On the policy side, there are internal and external risks. Internal risks are those derived from national policy and regulation; For example, recent legislative measures by the Chinese government focus on ESG regulation. These aim to increase the real standard of living of the population by reducing the cost of living and raising children, reducing wealth inequality, stopping large technological monopolies (similar to what happens in the United States with Facebook / Google) and fight corruption. Regarding external risks, we focus on geopolitical risks such as the conflicts between China and the United States during 2018 and 2019.

When it comes to the market, you have to look at the reasons for high volatility. In emerging countries it is due in most cases to market panic (herd behavior), but it could offer attractive opportunities for active investors willing to invest in bonds at attractive prices. Another risk to watch out for is secondary market liquidity.

That said, the Chinese ESG bond market is too big to ignore, and investors should keep three considerations in mind when investing in this market.

First of all, The Chinese onshore market is now the second largest in the world after the US. Chinese offshore dollar bonds, excluding Hong Kong, account for about 50% of the Asian bond market, while about 45% of Asia’s ESG bonds are from China. China has been the largest issuer of ESG bonds on the continent since 2013, followed by Korea.

Second, diligent financial analysis of companies remains crucial, as the ESG rating does not always positively correlate with return on investment. For example, Kaisa, a Chinese real estate company has a satisfactory ASG rating (‘Low Risk’ from Sustainalytics; ‘Medium Range’ from S&P / MSCI / Bloomberg), but is in crisis now. In fact, Kaisa’s bonds fell 60% last year.

In third place, ESG bond issuance is growing as the ESG profile in China improves. The main negative sectors for ESG (coal / steel / cement manufacturing) are not the main components of Chinese overseas bonds. ESG criteria are also the trend of China’s top issuers, as we have witnessed an increase in green and sustainability bond issues.

There have been rapid improvements in China’s disclosure requirements, for example with the taxonomy to be published by the International Platform for Sustainable Finance (IPSF), co-led by China and the EU; in turn, there is the mandatory disclosure of environmental information and listed companies must publish administrative sanctions derived from environmental issues; the exclusion of “clean coal” and other fossil fuel projects from eligible projects from the green bond catalog is another measure.

Furthermore, formal inter-ministerial approval of the listing of variable interest entities (VIEs) may be required in the future.

Among Chinese bond investors, large fund managers will need to assess climate-related risk scenario analysis, including scope 1 and 2 issues, starting in November 2022. In addition, independent non-executive directors who have been in office for more than nine years must request the approval of the shareholders for their re-election.

Once the risks are considered, we continue to see pockets of opportunity in the Chinese bond market, which offers absolute, but also risk-adjusted, returns that are higher than other markets throughout the cycles, especially after effective risk management. Chinese bonds also offer diversification to global portfolios, with more depth / breadth than many developed and emerging market regions.

It is important to note that international investors continue to heavily underweight Asia / China and we expect investors holding indexed portfolios to add exposure to Chinese bonds, after bonds are included in the major indices.

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