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How to approach China onshore bonds roll-out

Does Chinese onshore debt represent a better alternative than scores of other EMD options and what are the risks?


David Burrows

International investors used to be excluded from Chinese markets because the government preferred to keep its capital markets free of foreign capital flows. But the landscape has changed in recent years as the Chinese authorities have introduced various schemes to enable international investors to access this enormous market.

In April 2019, the Bloomberg Barclays Global Aggregate Index, added Chinese government and high-quality renminbi (RMB) bonds for the first time in history.

The addition of these securities is being phased in over a 20-month period. When fully accounted for in the index, local currency Chinese bonds will be the fourth largest currency component following the USD, euro and Japanese yen.

Turning point

The opening of the domestic Chinese bond market to international investors marks a tipping point, according to Gregory Suen, investment director, fixed income, at HSBC Global Asset Management.

“The inclusion will change the way China bonds are represented, marking not only China’s debut in the global bond markets but also a tipping point for global fixed income investing in general,” he says.

Qinwei Wang, senior economist at Amundi, agrees 2019 could be a milestone year for Chinese bonds and argues that the inclusion by Bloomberg Barclays Global Aggregate Index may be just the first step.

“It implies inclusions by other major indices of China’s bonds are not far away. Already, FTSE Russell is conducting a separate review, due this September, on whether to include Chinese local currency government bonds within its flagship gauge of sovereign debt, the World Government Bond Index.”

Wei Zhang, portfolio manager at Matthews Asia, shares the view the benchmark inclusion is important and makes the point that China’s bond market is one of the few large bond markets that remain essentially untapped by foreign investors.

“As the bond market slowly opens up, it likely will present a historic opportunity for foreign investors to participate in a market that offers relatively attractive yields when compared with other major bond markets such as the US, Japan and Europe, low correlation when compared against other major asset classes and low currency volatility due to a managed currency regime,” he says.

Zhang argues these defining qualities of the Chinese bond market will attract significant foreign investor attention.

Guan Yi Low, chief investment officer, fixed income, at Eastspring Investments, says access to the Chinese onshore bond market has improved since 2018 for foreign investors via registration on China Interbank Bond Market or on Bond Connect.

However, she stresses the inclusion in a widely followed global bond index still represents a turning point, as it broadens participation beyond the current group of reserve managers to include index trackers, ensuring more stable and persistent investor flows over time.

Mixed attraction

Suen insists diversification is the silver bullet argument for investing in RMB bonds, as they are largely driven by domestic policies and onshore supply and demand, and don’t always corollate with the rest of the world.

As for whether Chinese bonds represent a better investment option than the scores of other emerging market debt (EMD) options already available, Wang says relative to other emerging markets, the carry of Chinese bonds is unattractive for many investors.

However, he notes that the high carry options in emerging markets typically come with high volatility. He suggests Chinese bonds could provide lower but more stable returns and, from a medium and long-term perspective, Chinese bonds could become a meaningful part of a portfolio.

When it comes to the major developed markets, Wang’s take is that the carry of Chinese bonds is already attractive, although it will take some time before global investors feel comfortable investing in China’s local bond markets.

Matthews Asia’s Zhang has a similar view: “Compared with other emerging market debt, Chinese bonds do not offer across-the-board higher yield.

“However, when Chinese bonds are adjusted for the lower volatility of the currency, we believe the risk-adjusted return is attractive.”

Eastspring’s Yi Low believes Chinese government bonds offer an entirely different proposition to existing emerging market debt (EMD) options. “EMD has traditionally been a non-core allocation: that is it needs to feature a high enough yield in order to attract tactical investors.

“This makes EMD more volatile than bond markets in the US, Europe and Japan, which are anchored by domestic investors who respond to domestic economics.”

She adds: “Chinese government bonds being a largely domestically driven market will be more similar to the latter group than to EMD. Its low correlation to both developed and emerging market bonds potentially provides active managers with alpha opportunities and diversification benefits.”

Active approach

This distinction between Chinese and emerging market debt is something Omar Gadsby, head of fixed income fund selection at Credit Suisse, picks up on.

According to Gadsby, China should not be lumped in with emerging markets as a whole. The Chinese bond market is the third largest in the world, behind the US and Japan, and so he says there should be a clear distinction between emerging markets ex-China, with China treated independently.

As with any Chinese investment, there is always an element of ‘buyer beware’ due to the risks associated with a slowdown in China’s growth or corporate debt levels.

But rather than view the current slowdown in the Chinese economy as a headwind for the Chinese bond market, Wang views the bond market as a possible solution.

“The high corporate debt problem and slowdown of the economy have largely reflected structural issues in China’s financing system. A lack of efficient and transparent financing channels has caused money to flow into inefficient, low-profit and high-debt places.

“A typical example was that a large part of semi-fiscal spending was financed through shadow banking into local government financial vehicles and some SOEs [state-owned enterprises], which was counted as part of corporate debt.”

Wang says this underpins China’s efforts to reform its bond markets by improving market structure, strengthening regulations and allowing more individual defaults.

“The inclusion process takes Chinese bond markets closer to the international standard, making them more transparent, market-driven and therefore efficient. This could help guide money into more efficient companies and sectors and reduce debt problems in the medium and long term.”

He concludes: “One of real risks is how to manage the capital flows in and out of the country during this process.”

Gadsby also focuses more on opportunities than risks. “No doubt we will see more credit defaults, but this market is big and largely untapped. Undoubtedly, effective analysis of bond issuers becomes critical.”

He adds: “Most asset managers are looking to increase their exposure to China. It makes sense, when allocating, to follow an active strategy rather than a passive one.

The DWS Invest Asian Bonds fund (see chart 2) is one I would pick out. It is flexible in its strategy and can reduce and add risk when deemed necessary.”

Zhang echoes these sentiments. “When it comes to investing in Chinese bonds, we don’t believe all corporations (and/or SOEs) should be considered equal. Security selection is key to generating competitive returns while avoiding defaults. That’s why we believe in active management when it comes to China, rather than passively following indexes.”

Stable currency

An enduring concern about China is that the country is heavily overleveraged. But is this really the case when you factor in the size of the economy?

Gadsby thinks not. “If you consider the fact that the ratio of bond market cap to GDP in Japan is 2.5 times; in the US 2 times and in China just 1 times, you see that China is a lot less leveraged than the other main markets,” he says.

As for currency risks, he argues that China will under no circumstances rely on yuan depreciation to stimulate exports. He points out that GDP growth is far more about consumption than exports, meaning there is no incentive for China to weaken the currency to boost growth.

He believes a stable currency that is more transferrable is supportive for a healthy bond market.