More importantly, what makes China’s onshore market so appealing is not its size but the set of investor-friendly clauses that it provides. These clauses have a positive impact on the convexity characteristics of convertible bonds.
Mirroring the phenomenal growth of its economy, China has become the world’s second-largest equity market by market capitalisation. However, this huge economic potential is not yet reflected in global indices, and the high volatility shown by Chinese onshore equities is causing resistance among global investors when considering a standalone allocation to mainland China. Since late 2016, the A-share market (the CSI 800 Index) has exhibited an annualised volatility of 19% with three drawdowns exceeding 30%.
Although often overlooked, Chinese onshore convertible bonds (represented by the CSI Convertible Bond Index) have a role to play in global asset allocations. Provided you rely on local expertise to access this market, Chinese convertibles can provide ample exposure to China's domestic growth, while benefiting from much less volatility than the A-share market. Since the end of 2016, they have outperformed onshore equities with an annualised return of 5.6% versus 3.3%. As for their annualised volatility, it has been contained to half that of equities.
The second-largest convertible bond market in the world
The first onshore convertible bond in China was issued in November 1992. After a slow takeoff, the market has grown dramatically in recent years, from 24 issuers and a total market capitalisation of CNY 63 billion (USD 9 billion) at the end of 2016 to 460 issuers and a total market capitalisation of approximately CNY 972 billion (USD 131 billion) at the end of December 2022.
The Chinese onshore convertible bond market is now the second-largest in the world, after the United States’.
A complementary investment bucket
Onshore Chinese convertible bonds prevail as a complementary opportunity set because there is no overlap with Chinese companies in H-shares (Chinese companies listed on the Hong Kong Stock Exchange) or ADRs (Chinese companies listed in the United States). In this sense, onshore convertible bonds provide a pure exposure to the A-share market. In addition, the composition of the onshore convertible universe offers diversification from market-cap and sector perspectives.
Unique investor-friendly features
More important than the size, the attractiveness of Chinese onshore convertible bonds stems from specific features that set them apart in the global convertible universe. First, they have unique investor-friendly clauses which structurally reinforce their bond floor and improve the behaviour of the asset class during downside equity movements.
A second key difference is that Chinese convertible bonds are all rated and traded on an exchange, while global convertible bonds are traded over the counter. This allows full transparency in terms of market liquidity, trading volumes and prices.
Unparalleled convex characteristics
When considering convertible bonds, investors look for convexity, namely an asymmetric risk/return profile, which enables them to capture more of the upside than of the downside of equity markets. Chinese onshore convertible bonds display exceptional convexity characteristics: since the end of 2016, their downside capture has been limited to 30%, while their upside capture has been maintained at 49%. During this period, these have been the most attractive convexity characteristics across all regions of the world.
Nicolas Delrue
Matthieu Tournaire