Jean-Charles Sambor, head of global emerging market debt, explains why Chinese fixed income offers unique opportunities to global bond investors.
- In today’s world of negative bond yields, China's onshore fixed income markets really stand out, offering nominal yields above 3% for 10-year government bonds
- Besides offering diversification via a relatively low correlation with other asset classes, Chinese onshore fixed income is denominated in renminbi (RMB), a currency that stands to benefit from strong inflows as it gains its place among the world’s reserve currencies
- Chinese bonds offer strategic exposure to long-term trends such as the inclusion of China in global bond benchmarks, the growth of China's pension industry, and of course China's status as one of the world's largest economies.
Why are Chinese bonds so important for global bond investors?
Firstly, with outstanding issuance of around USD 14 trillion, China is now the world’s second largest sovereign bond market. As such, global bond investors simply cannot afford to ignore it. Funds tracking global bond benchmarks are increasingly incorporating Chinese bonds. Chinese fixed-income instruments will inevitably become more prevalent in international investors’ portfolios. This process is underway but, in my opinion, it has much further to run.
In addition, in an environment where fixed income investors are starved of yield on sovereign bonds, Chinese onshore government bonds offer positive yields. That matters in a world where for the first time, in 60% of the global economy — including 97% of advanced economies — central banks have pushed policy interest rates below 1%. In one-fifth of the world, policy rates are negative.
For multi-asset investors, positive real yields are critical in protecting real income returns. Chinese real yields on 10-year government bonds have been consistently higher than those in developed markets during the past five years. Since 2019, this differential has increased significantly.
This is partly explained by diverging monetary policy – G3 central banks have pushed their real yields steadily below zero – where we expect they will stay for some years yet. Despite strong GDP growth in China over the last 10 years, inflation has remained under control.
As a result, China now has inflation rates similar to those in developed economies but significantly higher real bond yields. This makes Chinese bonds a standout opportunity, in my view.
The relatively low correlation of Chinese bonds to almost all other asset classes is another consequence of China's monetary policy being largely independent from those of other major economies. China's growth is more dependent on internal dynamics than on other economies.
This low correlation also reflects that China remains largely a self-sufficient capital market. Currently, China is one of the largest net creditor nations in the world. Domestic investors are dominant in China, having the largest deposit base in the world, equivalent to around USD 40 trillion and still growing.
Onshore renminbi bonds
Investors should understand that China’s bond market is composed of three different segments of which the largest by far is the market for Chinese bonds listed onshore and priced in renminbi (see Exhibit 1 below for a breakdown by sector of the onshore Chinese bond market).
This represents around 90% of China’s bond market (the other segments being Chinese debt issued in offshore renminbi, listed in an offshore clearing centre like Hong Kong, and China’s foreign currency issuance).
Exhibit 1: The onshore bond market is by far the largest segment of China’s bond markets – the graph shows the breakdown (in %) of China’s onshore bond market by sector
Note that the renminbi is the official currency of China where it acts as a medium of exchange, whereas the yuan (CNY) is the unit of account of the country's economic and financial system
Source: Bloomberg, PBoC, CCDC, SHCH, JP Morgan, 2019
Improved accessibility to onshore bonds for global investors
Several recent changes in China have furthered the investability of onshore bonds, which over time will be part of the tools China uses to promote financial stability, while also offering a new investment frontier to global fixed-income investors.
Chinese regulators have made considerable efforts to increase the accessibility of the onshore bond market to foreign investors. Programmes like the Bond Connect scheme and China Interbank Bond Market (CIBM) Direct represent major breakthroughs as they allow foreign investors to trade Chinese bonds more easily and freely. Investors can now proceed via an offshore account and are no longer subject to restrictions such as quotas or lock-up periods.
Up until 2018, the only option for offshore investors to hedge their renminbi exposure was via deliverable offshore or non-deliverable onshore forwards. However, in 2018, China announced that onshore deliverable forwards would be made available to foreign investors as a hedging tool.
Hedging of renminbi exposure is now available to foreign investors accessing the market via both the CIBM direct and Bond Connect schemes. The cost of hedging versus the US dollar has fallen significantly to levels well below the historical average of recent years.
What is the outlook for the renminbi?
We are positive on the outlook for emerging market currencies generally in 2021 and on the renminbi in particular. We anticipate strong capital flows back into emerging markets as risk appetite rises once vaccines to COVID-19 become available.
China, we think, will lead the way in 2021as the fundamentals for the Chinese currency are positive: the balance of payments is healthy, exports are growing strongly and import growth is relatively contained.
We have already seen significant inflows into Chinese equity markets, but flows into the onshore Chinese bond market have been three to five times stronger than equity inflows.
China is keen to promote greater cross-border use of the renminbi and Beijing is doing its utmost to attract foreign investors to develop China’s financial markets. The ultimate goal is to improve the allocation of capital and develop long-term pension and insurance products.
We see considerable scope for the renminbi to appreciate, but it will not be without volatility. Indeed, the Chinese authorities see some volatility as part of the process of exposing the currency more to market forces. They are seeking a more market-based exchange rate.
Exhibit 2: The Chinese yuan has appreciated significantly in 2020 - graph shows changes in exchange rate of the yuan to US dollar between 02/01/2020 and 09/11/2020. Note that the renminbi is the official currency of China where it acts as a medium of exchange, whereas the yuan is the unit of account of the country's economic and financial system).
Source: BNP Paribas Asset Management/Bloomberg as of 15/11/2020
Inclusion of China in global government bond indices - A game changer?
The inclusion of Chinese government bonds (CGBs) in global bond indices is the elephant in the room for global bond investors. I have been covering this market for over 20 years but things are moving even faster than I expected. It is very exciting. Foreign flows into China’s government bond market have been supported by the following news:
- The 20-month phased inclusion of Chinese government and policy bank bonds in the Bloomberg Barclays Global Aggregate Index, which began in April 2019.
- JP Morgan's decision, in February this year, to start adding Chinese government bonds in its Government Bond Index Emerging Markets (GBI-EM) series over 10 months.
- The announcement last month by FTSE Russell that Chinese Government Bonds will be included in the FTSE World Government Bond Index (WGBI) starting in October 2021 (this date is subject to final affirmation in March 2021).
Index inclusion recognises the efforts made by the Chinese authorities to simplify market access and regulation, and to resolve trading issues, among other things. In the process of opening up Chinese capital markets, this will be another milestone. I expect USD 200-300 billion in inflows into Chinese government bonds just related to the index inclusion.
Index inclusion should boost foreign ownership of Chinese government bonds. It has already risen from 2%-3% to around 8% now. In the medium term I believe it could easily rise to 20%-25%.
I think this is a conservative estimate because if foreign ownership rises to the level that we see in South Korea – around 15% – it would imply inflows into the Chinese government bond market of up to USD 1 trillion. That is why index inclusion is potentially a game changer for one of the most under-owned sovereign bond markets in the world.
Also listen to Market weekly – Opportunities in Chinese fixed income (podcast) with Jean-Charles Sambor
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*According to the same report, foreign investors held around 8% of Chinese government bonds
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