By Yen Nee Lee, CNBC

One year ago, China made a major move to open up its domestic, or onshore, bond market. But the sector is now facing a trying time as investors brace for a greater number of payment defaults in the months ahead.

That’s coming at a time when the Chinese economy faces the threat of a further slowdown amid an escalating trade conflict with the U.S., which could rattle investors already cautious about putting money in yuan-denominated assets.

As it is, there are signs that investor sentiment on China has been hit, Hou Wey Fook, chief investment officer of Singapore’s DBS Bank, said Monday. He pointed to the recent sell-off in shares of Chinese companies listed in Shanghai. Last week, that market entered bear territory, meaning it had fallen at least 20 percent from recent highs.

That has happened even though bond defaults in the world’s second-largest economy are more “idiosyncratic” than widespread and the “default rate is still very low,” Hou told reporters at a briefing.

The first six months of this year saw 11 Chinese companies failing to pay the principal or interest on 20 bonds worth a total of 19.9 billion yuan ($3 billion), according to Reuters. That compares with 26 defaults worth 26 billion yuan in the whole of 2017.

Those numbers are likely to increase as China’s efforts to clean up its financial sector have made borrowing costs higher, and more companies will find it harder to repay their debt, experts said. In the coming quarter, more than 2,000 bonds valued at 2.3 trillion yuan ($342.72 billion) will mature, Chinese state-owned media China Dailyreported, citing data from Wind Info.


China’s opening up is still a work in progress

The increasing number of defaults coincides with the one-year anniversary of China’s “bond connect” program, which the chief executive of Hong Kong’s stock exchange, Charles Li, called a “huge breakthrough” ahead of its launch.

The initiative allows international investors to trade bonds in mainland China through Hong Kong with fewer limitations. Older programs have a cap on the investment amount, and require foreigners to go through a lengthy process involving account opening and finding a clearing agent with international settlement.

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There are now 356 overseas institutional investors registered to trade through the bond connect as of last month, while total foreign holdings of Chinese bonds — not limited to those bought through the program — grew 62.7 percent from July last year to 1.44 trillion yuan ($214.76 billion) in May 2018, according to official statistics.

But that’s still less than 2 percent of the roughly $12 trillion Chinese bond market, which is “very small” compared to the country’s economic importance, said Andy Seaman, partner and chief investment officer at Stratton Street.

“The fact that many firms have bigger investments in U.S. high yield and peripheral European bond markets than they do in Chinese government bonds remains perhaps the biggest mystery in global financial markets,” Seaman told CNBC in an email.

He added there are several issues with the bond connect that have held back greater investor participation, including uncertainties over taxation, and a delay in the delivery of bonds and receipt of payment. Still, those issues are being ironed out and the program is “already a major success” in providing greater access to the world’s third-largest bond market, he said.


A healthier China in the making

In addition to the credit defaults and technical kinks in the bond connect program, the Chinese currency is expected to weaken further— which gives foreign investors another reason to stay away because that threatens their potential monetary returns.

But China has to go through some pains to strengthen its financial industry, experts said. Allowing problematic companies to fail is necessary so that the remaining healthier firms can help to draw foreign investors into China, they added.

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“We believe orderly bond defaults could foster healthier development of the onshore bond market, increasing its attractiveness to foreign investors and facilitating China’s capital account liberalization over the longer run,” Morgan Stanley analysts wrote in a report in June.

The defaults that have emerged among Chinese companies make up just 0.2 percent of the outstanding corporate bonds. That’s “significantly lower” than the global corporate default rate of 1.2 percent in 2017, the analysts added.

But for a Chinese government used to coming to the rescue of companies, especially state-owned ones, letting more firms fail in the coming months will be a test of its “commitment to reforms,” ANZ analysts wrote in a June report.

“A major project of the government is to crack ‘implicit guarantee’, to draw a clear line between fiscal and non-fiscal liability,” they said. “There will be many more credit default events reported by the media … It will be a test of the government’s commitment to its reforms.”