The rising volatility in the onshore bond market since mid-December last year has caught the attention of many market participants. According to media reports, the market turbulence was triggered by the default scare of bond under custodian of Sealand Security, which in turned stirred up concerns over counter-party risks. The timely resolution of the dispute has calmed the credit market, resulting in reduced volatility. However, issuance of credit bond continued to be sluggish, indicating that there is still sizable underlying dislocation in the market. In this note, we share our thoughts regarding the probability of further price adjustments in credit bond market. On the other hand, government and quasi-government bond markets may endure less volatility than the credit bond market, as the former enjoys relatively better liquidity, stronger credit (& rating) support, and potentially less supply in 2017.

Negative net issuance and anemic transaction volume signals continued dislocation in the credit bond market. Although the bond market volatility has declined after the Sealand incident was resolved on December 28, gross issuance of credit bonds has been anemic and net issuance was kept in negative territory. Total monthly net issuance of credit bond (i.e. corporate bonds, enterprise bonds, medium term notes, and commercial paper) plummeted to RMB -225 bn in December 2016, first time since December 2013. Net issuance value in 2017 remained negative so far. Furthermore, the transaction volume of credit bonds has also declined, indicating lackluster market interest. In our experience, the persistent negative net issuance and dwindling transaction volume may be the first signs indicating that the price of credit bonds has not reached the “market-clearing level”.

The probability of further bond market volatility will rise along with the duration of this “credit bond issuance draught”. Understandably, the probability of defaults/ delayed payments will rise with the length of the “vacuum”, where the credit bond market fails to provide liquidity support to the issuers. Since 43% of the credit bond issuance in 2016 was short-term commercial papers with duration of less than 1 year, the stress within the credit bond market and the probability of localized credit events will escalate rapidly if the current market condition (of negative net issuance) persist. On the other hand, resumption of abundant bond issuance and looser financial conditions may ease the tension.

In the near term, we would continue to closely monitor the net issuance of credit bonds, as well as the interbank and exchange market interest rates to gauge the potential pressure for the credit bond market. The credit bond maturing amount will increase notably in 2017 compared with 2016 due to the rapid expansion of the credit bond market since 2015. Furthermore, the amount of bond issuance with lower credit rating has grown visibly since March 2016. Our analysis shows that the amount of credit bond maturing in 2017 will rise notably from March 2017 onwards, leading to an increase of the bid for funding in the credit bond market and potentially tighter liquidity. Therefore, it is key to observe how well the credit bond market functions as the funding source for its issuers and how loose the overall liquidity condition is, in order to gauge the potential risks of further credit bond market correction.

Immediate concerns aside, there may be further pressure for bond pricing to correct (credit bonds in particular) given the current macro backdrop. Although the media and some investors blame the Sealand incident as the trigger for the recent credit bond market correction, the credit bond yields have been creeping up since October 2016, together with the overall bond yield. In our view, it is no coincident that bond yields started to rise shortly after PPI turned positive, as rising PPI has been a reliable coincident indicator of profitability trend for China’s non-financial sector. As we have repeatedly mentioned in our recent research, bond yield tends to rise with inflation expectations and corporate profitability, since savings may start to favor active investments (such as investment in production and equities) compared with passive investments (e.g. fixed income products and cash). The same logic applies to the movement in credit bond yield.

Potential bond market volatility may post challenges for financial institutions and asset management entities with concentrated holdings of credit bonds, especially those under a market-to-market mandate. As we have discussed in our previous research, bond market correction may lead to temporary stress for financial institutions with concentrated holding of fixed asset products, especially those heavily invested in credit bonds with poor liquidity. The scale of China’s asset management business has grown rapidly since 2015, especially that of private funds and fund subsidiary cooperation. More specifically, the scale of China’s asset management industry has grown to RMB 48.9bn by 3Q2016, a 138% rise or RMB 28.4 trillion expansion in size since 2015. Meanwhile, the share of fixed-income-oriented or (equity and fixed income) hybrid funds has increased notably. On the other hand, investment in bonds has also increased for the smaller banks.

However, barring sizable policy missteps, we do not expect the potential volatility in the bond market and rising bond yields to derail the ongoing reflation. It is worth noting that despite its rapid expansion, credit bond market financing remains a small part of China’s total social financing – total credit bond net issuance took up 17% of total social financing in 2016, while total outstanding credit bond makes up for only 9.2% of outstanding social financing. In other words, different from the developed markets, China’s overall weighted average lending rate is predominately decided by the price of the bank loans rather than corporate bond yield. As of 3Q2016, China’s banking system overall weighted average lending rate had remained on a downward path. Furthermore, the rapid rise in inflation of manufactured products can more than offset the moderate increase in funding cost, pushing the real interest rate lower and the reflation further-- PPI for downstream  manufactured products rose 5.1% YoY and  21% MoM annualized in  December 2016. Therefore, barring a persistent and significant rise in the financial conditions triggered by delayed policy reactions, the potential adjustment in bond yield is unlikely to derail the ongoing reflation.