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By Mark Evans, Sales Manager and Wilfred Wee, Portfolio Manager

Foreign investors starting to allocate to China

Sustained policy reform over many years has helped China to cement its position as a major engine of global growth. China’s rising prominence in the global economy and the opening up of its capital markets make it an attractive investment destination for both global asset management companies and end investors. Over the last few years, we’ve seen a trend increase in the holdings of onshore renminbi (CNY) bonds by foreigners, led by global reserve managers. By the end of the first quarter 2018, foreigners held CNY 1.4 trillion of onshore CNY bonds, three times the amount that was held four years prior.

 

Figure 1: Onshore CNY bonds held by overseas entities

Source: Bloomberg as at 31.03.18

Significantly under-represented in global portfolios

Despite being the world’s second largest economy and having the third largest bond market, exposure to China remains low in global portfolios. As access to China’s capital markets improve and foreigners gain more insight into its fixed income asset class, we believe that Chinese bonds will feature increasingly in their portfolios. We expect that fixed income inflows into China will be a structural phenomenon in the years ahead.

Figure 2: Sizes of domestic government debt securities markets

Source: Bank for International Settlements as at 30.09.17

Figure 3: General government total debt securities

Source: Haver Analytics as at 30.09.17

Further inflows following index inclusion

In March 2018, Bloomberg announced1 that it would add renminbi-denominated government and policy bank securities to the widely followed Bloomberg Barclays Global Aggregate Index from April 2019. While this is conditional2, it is telling that on inclusion, local currency Chinese bonds will be the fourth largest currency component following the US dollar, euro and Japanese yen. Indications are that China’s weight will be 5.5% of this overall index.

At the same time, if China were to be included in the FTSE (previous Citi) World Government Bond Index at similar weights, as well as the widely followed set of JPM Emerging Markets Government Bond indices, its bond market would benefit from further inflows. If investors merely tracked these three index families, some US$300 billion would be invested in Chinese bonds over time. While not insubstantial, such inflows would only represent a fraction of China’s US$11 trillion onshore bond market and be easily absorbed.

Aside from sheer size and relevance, we believe that investors will increasingly favour Chinese bonds because of their potential to significantly enhance overall portfolio risk-adjusted returns. Below we outline some of the yield and diversification benefits of Chinese fixed income.

An attractive yield pick-up

Chinese bonds offer healthy yields, providing an attractive pick-up versus developed market peers. The yields of onshore and offshore (‘dim sum’) Chinese government bonds are generally higher than those of large global peer markets.

Figure 4: Onshore CNY Government bond yields versus DM bond yields (%)

Source: Bloomberg, JPM as at 27.04.18

Figure 5: Offshore CNH Government bond yields versus DM bond yields (%)

Source: Bloomberg, JPM as at 27.04.18

Yield pick-up comes with quality

The credit rating of China’s sovereign debt is strong, and stacks up well against global developed market peers.

Figure 6: Foreign currency issuer ratings

MOODY'S S&P FITCH
Canada Aaa AAA AAA
Germany Aaa AAAu AAA
US Aaa AA+u AAA
UK Aa2 AAu AA
France Aa2 AAu AA
Korea Aa2 AA AA-
China A1 A+ A+
Japan A1 A+u A
Malysia A3 A- A-
Poland A2 BBB+ A-
Mexico A3 BBB+ BBB+
Italy Baa2 BBBu BBB

 

Source: Bloomberg as at 30.04.18

Developed market characteristics

China’s bonds tend to be viewed as being emerging market assets in terms of access and operations. However, we believe Chinese government bonds more closely resemble developed market (DM) assets, in terms of volatility and size. Over various time horizons, the volatility of Chinese government bonds has been lower than most DM bonds. Moreover, the volatility of the renminbi has been lower than most (if not all) DM currencies.

Figure 7: Average 10 year Government bond yield (%), annualised volatility (%), last 1 year

Source: Bloomberg as at 30.03.18

 

Figure 8: Average 10 year Government bond yield (%), annualised volatility (%), last 3 years

Source: Bloomberg as at 30.03.18

Figure 9: Average 10 year Government bond yield (%), annualised volatility (%), last 5 years

Source: Bloomberg as at 30.03.18

 

Figure 10: Average 10 year Government bond yield (%), annualised volatility (%), last 7 years

Source: Bloomberg as at 30.03.18

Currency volatility

Figure 11: Annualised FX volatility (%, US$ Spot returns)

Source: Investec Asset Management and Bloomberg as at 30.03.18

When considering these factors, we would argue that allocations to Chinese fixed income should be considered as part of overall DM bond exposures.

Diversified and attractively rated credit

Outside of sovereign bonds, most Chinese corporates that have issued in the international dollar (‘kung fu’) bond market – which reference internationally accepted credit ratings by Moody’s, S&P and Fitch – are also of relatively high credit quality. It’s easy to generalise that Chinese real estate bonds characterise the Chinese bond opportunity set. The reality, however, is that Chinese dollar bonds are diversified across sectors and predominantly rated investment grade.

Figure 12: Ratings

Source: JP Morgan Asia (USD) Credit Index: China, Hong Kong, Macau, Taiwan. Bloomberg as
at 28.02.18

Comparing like for like, Chinese corporates can offer spread pick-up with lower duration risk. Over the market cycle, the credit spreads of Chinese companies have been more than US BBB-rated peers, with lower duration risk.

Figure 13: China credit spreads versus US BBB credit spreads (bps)

Source: Bloomberg, JP Morgan as at 27.04.18

Trade surplus supportive of renminbi

Invariably, investors are exposed to the Chinese currency when holding renminbidenominated bonds, whether onshore (CNY) or offshore (CNH). We believe that the renminbi can maintain and enhance its value versus major currency peers over the years ahead. Anchoring this view will be China’s ability to consistently run a trade surplus against major economies.

Figure 14: US Trade Balance with China

Source: U.S Census Bureau as at 31.03.18

Figure 15: Eurozone Trade Balance with China

Source: Eurostat as at 28.02.18

Figure 16: Japan Trade Balance with China

Source: Ministry of Finance Japan

We believe that China will continue to be the ‘workshop’ of the world — focusing not only on the production of toys and basic electronics, but increasingly on high-end machinery and gadgetry as industries move up the value-added chain. The services industry should also continue its transformation, with more and more Chinese workers swapping their blue collars for white ones. Given that a country’s currency represents the value of goods and services produced, we believe that there is a structural element supporting the relative strengthening of the renminbi.

Low correlations

Allocating to Chinese fixed income can help improve overall portfolio risk-adjusted returns because of the diversification benefits that Chinese bonds provide. The returns of Chinese fixed income tend to be lowly correlated to other asset classes as China’s interest rate movements are predominantly determined by domestic factors.

Figure 17: Correlation between Chinese fixed income and other asset classes

OFFSHORE
CNH BONDS
OFFSHORE
US$
CHINA
BONDS
GLOBAL
DM
BONDS
GLOBAL
DM
EQUITIES
GLOBAL
EM
LOCAL
BONDS
GLOBAL
EM US$
BONDS
GLOBAL
EM
EQUITIES
Onshore CNY
bonds
-0.07 -0.22 -0.19 -0.22 -0.07 -0.18 -0.22
Offshore CNH
bonds
  0.47 0.28 0.45 0.43 0.39 0.58
Offshore US$
China bonds
    0.29 0.60 0.67 0.81 0.69
Global DM bonds       0.19 0.56 0.48 0.27
Global DM
equities
        0.71 0.65 0.88
Global EM local
bonds
          0.82 0.81
Global EM US$ bonds             0.74

 

Source: Bloomberg, December 2017. Onshore CNY Bonds: JP Morgan Asia Diversified Broad China Index TR; Offshore CNH Bonds: Markit iBoxx Asia Local Bond Index China Offshore TR Index Unhedged; Offshore USD China Bonds: JP Morgan Asia Credit Index China TR; Global DM Bonds: JP Morgan Government Bond Index Global Unhedged USD; Global DM Equities: MSCI World Index; Global EM Local Bonds: JP Morgan GBI-EM Global Diversified Composite Unhedged USD; Global EM USD Bonds: JP Morgan EMBI Global Diversified Composite; Global EM Equities: MSCI Emerging Markets Index. Correlations calculated based on monthly returns data, from 2008 to 2017

While these correlations may pick up as China integrates with the global capital markets, we believe they will be limited as China will increasingly become a maker of monetary policy and markets, rather than a taker of international prices.

Conclusion

We believe China will continue to be a major driver of global economic growth. The opening of its capital markets, sheer size and global economic position mean that investors are no longer questioning whether they should invest in China. Instead, the focus is now on how to gain an investment foothold in this economic superpower. We believe that Chinese bonds may significantly enhance investors’ overall portfolio risk-adjusted returns, given the yield and diversification benefits of Chinese fixed income.

General risks: The value of investments, and any income generated from them, can fall as well as rise. Past performance is not a reliable indicator of future results.

Specific risks: Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Investing in China: Investment in mainland China may involve a higher risk of financial loss when compared with countries generally regarded as being more developed. Developing market: These countries may have less developed legal, political, economic and/or other systems. These markets carry a higher risk of financial loss than those in countries generally regarded as being more developed.

 


 

1https://www.bloomberg.com/company/announcements/bloomberg-add-china-bloombergbarclays- global-aggregate-indices/
2The inclusion is conditional on several planned operational enhancements being implemented. Namely, implementation of delivery versus payment settlement, ability to allocate block trades across portfolios, and clarification on tax collection policies.

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