15 November 2017, 17:18 GMT
Since late 2015 we have seen 3 key structural financial market reforms unfold in China. I refer to them as "ABC", because they are that fundamental. "A", is the most important, namely the need to improve the cost and allocation of capital.
These charts help illustrate that China's number 1 financial market reform is unfolding before us. And it is happening thanks largely to China's rapidly developing onshore bond market, which is now the second largest ^ bond market in the world.
Why is this important?
Pricing capital more efficiently is critical, so that capital can be allocated and used in the best possible way. More simply, a poorly managed and inefficient business should not be able to borrow money at the same rate as their more profitable and well run competitor. Bond markets help with this process.
This does not mean that higher-yielding corporate bonds are badly managed companies, far from it. Even investment grade (IG) companies (and Sovereigns for that matter) can be poorly managed too. In contrast, high yield (HY) issuers are typically riskier because they are more leveraged or smaller in scale than higher rated companies. After all, higher risks require higher returns.
Thankfully companies, like people, often have an incentive to improve, reduce leverage and/or be more productive. Which means efficient, well run businesses should be rewarded with a relatively lower cost of funding (all-else-equal) and importantly that means less efficient companies should be penalised and in extreme cases perhaps restructure, default or just 'go away'.
So, in short, the charts show that China's developing bond market is starting to price capital (credit) better. The onshore bond market is not perfect by any means and there is still much room to go (and grow) but the improving ‘efficiency’ of pricing credit risk is certainly heading in the right direction. This dynamic is a necessary prerequisite to sustainable, healthy, long-term economic growth.
The good thing is that inefficient or semi-efficient capital markets are what active management exploits. What's especially exciting* is that none of this can happen easily without a functioning bond market and that is developing before our eyes.
^ On paper Japan has the second largest bond market but the Bank of Japan (BOJ) effectively owns all the government bonds these days, thanks to QE, QQE and YCC (what do they mean? Simply google "What does QQE and YCC mean”)
* Exciting is certainly subjective but all investors should care about this too. Whether you invest directly in China or not (just about everyone has indirect exposure to China) there are potentially wide ranging positive & negative implications which warrant a closer look.
Disclaimer text goes when content signed off.