As US interest rates rise, Chinese bonds might emerge as a winner
Shaw Yann Ho and Jason Pang say China’s monetary policy easing and inclusion in global indices make Chinese bonds attractive, with cross-border investment offering the best opportunity for returns
Earlier this week, the US Federal Reserve held interest rates steady and acknowledged rising inflation, but gave investors little indication that officials are worried about a rapid spike in prices or an abrupt slowdown in economic growth. This reiterated to the markets that the Fed will continue its measured path of rate increases. US government bond prices have inched higher as a result, with the yield on the benchmark 10-year Treasury note hovering around 3 per cent.
The debate in the US – over how quickly and to what extent the Fed can successfully normalise monetary policy – will continue, but an interesting observation for Asia is that US and Chinese bond yields are starting to converge.
Whereas US Treasuries are on the cusp of breaking through the top end of their range, potentially signalling the end of the 35- year bond bull market, Chinese government bonds have been pushed downwards by signs that China’s central bank is easing monetary policy as the economy slows. Following the People’s Bank of China cutting the required reserve ratio, the gap between Treasury and Chinese bond yields dropped to a multiyear low, which showcases the policy divergence across the two markets.
The question for investors here is whether the Chinese bond rally is set to continue.
One key element supporting the Chinese bond market – and suggesting that it will continue to do well over the longer term – is the rising participation of foreign investors.
Bloomberg recently announced that it would include yuan-denominated government and policy bank securities in its global aggregate indices from next year, adding over 380 securities by 2020. This means that the 5.49 per cent of eventual index weight for China bonds should translate into over US$110 billion in passive inflows, boosting the market’s prospects.
The inclusion decision also complements the renminbi as a reserve currency in the International Monetary Fund’s special drawing rights basket. Additional flows could be unlocked as other major indices such as WGBI and the GBI-EM continue to evaluate inclusion viability.
Foreign ownership of China’s relatively lower-risk government bond market sector is now approaching close to 6 per cent, having climbed by 2 percentage points in the last two years or so. Overall average foreign ownership across all sectors of the market, including government bonds as well as policy bank bonds and corporate credit, continues to hover around an average of 2 to 3 per cent.
Such foreign ownership levels are extremely low compared to most of the other Asian bond markets, which range from 10 to 40 per cent. This implies there is scope for Chinese bond holdings to increase over time, closer to 10 per cent as participation increases.
Apart from providing exposure to the world’s second-largest economy, yuan-denominated bonds look attractive from a macro as well as a total return perspective, offering highly competitive yields and a low correlation to developed market core rates due to the low foreign ownership.
China’s bond market average credit rating is A+, indicating that the market on average offers solid sovereign credit quality. Yet the market’s yield is the fourth highest in Asia.
Investing in yuan bonds is hardly a singular universe, as investors can gain access to China issuers in a number of different ways. The challenge and opportunity is extracting the best possible return for the lowest level of sovereign risk across onshore, offshore (dim sum) and dollar bond markets hedged back into yuan.
The most compelling alpha opportunities in China are in cross-border investment. This means being active across Chinese, dim sum and US dollar bond markets (hedged into yuan).
So far this year, onshore Chinese bonds have rallied and may continue to do so given global uncertainty, but dim sum bond yields have actually remained higher, suggesting offshore investments offer attractive value for both foreign and domestic investors from a rates arbitrage perspective.
Not only is there a powerful secular story supporting the China bond market in the form of incoming passive flows driven by increasing index inclusion, but the reserve currency status, competitive yields and low correlations will become increasingly important in a rising US rate environment. Indeed, the fact that Chinese government debt prices are rising just as US government debt prices are falling is evidence of the diversification this market can provide to investors.
Shaw Yann Ho is head of Asia fixed income and Jason Pang is portfolio manager at JP Morgan Asset Management