It is no secret that China’s bond market has had a rough year. Since January, both Asian and Chinese bond markets have underperformed other major global bond markets. Weakness has mainly come from China’s small, volatile US dollar-denominated offshore high-yield market, which has seen heavy selling amid a dimming property sector and new regulatory policy risks. More recently, the market focus has zoomed in on China’s heavily indebted developers that have missed interest payments and whether this is just the tip of the iceberg. A common belief among China bond investors has been that policymakers would provide a backstop for troubled state-owned enterprises and strategically important businesses. But they have shown an increasing tolerance for letting troubled companies go under, and investors are reassessing assumptions. This shift, coupled with regulatory scrutiny of various economic segments under President Xi Jinping’s “ common prosperity ” theme, is driving Hong Kong stocks further into bear territory. The market’s focus on real estate developers is understandable, although we should remember that recent headlines have focused on somewhat idiosyncratic risks at specific high-profile names. Extrapolating this to the entire credit market is a stretch. Moreover, it is important to look at the broader macro environment. Real estate as a sector has done well this year – property investment was up 11 per cent year on year as of August, while property sales were up around 16 per cent year on year. The average home price growth in seven major Chinese cities has ranged between 3.4 per cent and 4.5 per cent year on year in 2021. Looking at these metrics, Beijing is unlikely to respond with broad easing in the property market. In fact, its near-term priority has been to cool the market under the guise of reducing income inequality and supporting common prosperity. One cooling measure Beijing could take is to change the presale model to one based on sale on completion. This could have broad ramifications as developers with high funding costs may have to fold. Yet, the property sector is still the most important segment for China’s economy. If calculating direct and indirect output, property counts for around a quarter of gross domestic product, which means the tolerance for a property market downturn only goes so far. It will be difficult to predict when and how policymakers will intervene in this large but potentially overheating space. Short-term trading will be tricky. But looking further ahead, we could be witnessing the start of a deeper, more dynamic corporate credit market in China. Although it is now the world’s second-largest bond market, most private companies in China struggle to issue public debt since state-owned enterprises dominate issuance. Private firms that do not have the government’s explicit support are pretty much shut out. Companies that are not state-owned make up only a fraction of those that have issued bonds so far this year. Over time, fixed-income investors have also grown used to only investing in highly rated Chinese corporate bonds, and credit raters have tended to rate only state-backed and ultra-strong companies. This has led to a tiny onshore high-yield bond market – of China’s US$4.5 trillion onshore credit market, almost 96 per cent of rated bonds are AA or above. That could all start changing soon, as the People’s Bank of China recently released a circular outlining its priorities and road map to creating a high-yield bond market. It is feasible to imagine that regulators will make it easier in the future for private companies to issue bonds through lower registration fees, simplifying the approval process and allowing for more sophisticated financing products targeting high-yield companies. Will China succeed in cooling its property market? This would be a welcome development for yield-hungry bond investors, but there are obstacles. The biggest hurdle would be for regulators to demonstrate to the market that the era of implicit guarantees is over, creating unwanted market volatility and some potential credit events in state-owned firms and local government financing vehicles . This road map does give investors some confidence that the Chinese bond market is set to open even further, and the move could help it become the world’s largest. To get there, the government may have to allow more defaults from SOEs as well as smaller property companies that face greater risks under the current macro backdrop. It is unlikely that policymakers would permit a run of defaults since this would bring systemic and unmitigated risks to the financial system. China’s bond market is evolving before our very eyes. The result could well be a more mature and open market for issuers and investors. David Chao is a global market strategist (Asia Pacific) at Invesco