China's corporate bond market should continue to grow significantly over the medium to long term, as the regulatory framework liberalizes and corporates look increasingly to diversify fund-raising options away from bank lending, says Fitch Ratings.

In a report released on May 21, Fitch says it expects several key trends to emerge as the market matures and develops - including greater credit spread differentiation, a growing presence of non-state owned enterprises (SOEs) and rising offshore participation.

The share of Chinese corporate bonds has already expanded strongly, to 32% of the total domestic bond market at the end of 2014 from 3% at the end of 2004. Yet, the potential for growth remains significant, especially as government continues to gradually open the market to foreign investors and as corporates continue to be incentivized to issue bonds due to lower average funding costs than bank lending.

Future trends for the corporate bond market should differ from those over the past decade. SOEs, which have dominated the corporate bond market since the early 2000s, and local government financing vehicles (LGFVs) - which accounted for almost one-third of total corporate credit issuance in 2014 - are likely to diminish in relative significance.

SOEs accounted for around 90% of total outstanding domestic corporate credit bonds at end-2014, and 70% of all corporate credit bond issuers. Non-SOE access to corporate bond funding is likely to improve if the government continues to reduce administrative intervention in the corporate sector, allow SOE defaults, and lower regulatory barriers to entry to capital-market financing for the private sector. Fitch expects a registration-based mechanism to become the norm for primary market issuance, though the market could still remain subject to government policy intervention.

The role of LGFVs, which became increasingly significant in the corporate bond market in the last few years, should also reduce following government curbs to the expansion of LGFV debt toward the end of 2014, and regulatory changes allowing local governments to issue debt themselves.

More diversity among issuers, and the emergence of defaults, should ultimately contribute to greater credit spread differentiation. Some limited spread differentiation has already begun to emerge, despite the lack of default precedence of bondholders suffering losses. SOE bonds have started to trade at narrower credit spreads to the yield-to-maturity of central government bonds compared with non-SOEs of similar tenors. Cyclical sectors are also trading at wider spreads to less cyclical, asset-light sectors, and spreads are also widening between higher- and lower-rated corporate bonds.

Offshore investor participation should continue to rise as the Chinese bond market matures and develops. With a US$67 billion quota, 261 overseas institutional investors were allowed to invest in the Chinese bond market as of end 2014, with a further 300 billion renminbi (US$48.4 billion) quota allowed for renminbi-denominated bonds. Fitch expects Chinese regulators to open the onshore bond market further to foreign investors, but gradually.