For investors, Chinese bonds are rapidly becoming too important to ignore. In an exclusive interview, Asia Asset Management speaks to Shaw Yann Ho, head of Asia fixed income and Jason Pang, portfolio manager, both from J.P. Morgan Asset Management, to find out why this is the case.
Asia Asset Management: China’s making a clear effort to attract foreigners to its vast domestic bond market, seeking to pull in investors drawn to relatively high yields and a newly stable currency. Is it working?
Shaw Yann Ho: Yes. In fact, the unlocking of China’s enormous US$12 trillion bond market could be arguably the most pivotal change to global capital markets in the next decade. Foreign holdings in Chinese bonds today are miniscule, but as Beijing pulls down the barriers, the ripple effects of internationalisation will be significant.
Market reforms have been underway for quite a while in China, what makes it different now?
Jason Pang: Bloomberg’s milestone recent decision to include Chinese yuan-denominated government and policy bank securities in its global aggregate indices from next year, adding over 380 securities by 2020, is the latest in a procession of signs that China onshore bonds are rapidly becoming a larger part of global investors’ portfolios. Although it is contingent on improvement in settlement terms and tax clarifications, the 5.49% eventual index weight should translate into over $110 billion in passive inflows, further boosting the market’s prospects – and not including positioning by active managers taking a more substantive role. The inclusion decision also complements the Chinese yuan as a reserve currency in the [International Monetary Fund’s] special drawing rights (SDR) basket.
With a 20-month phase-in period, this implies a 27.5 basis point index weight of market impact per month, or $5 to $6 billion worth of passive purchases each month starting from April 2019. In the meantime, domestic investors remain dominant in terms of price action and, so far this year, 5-year CGB [China government bond] has already rallied over 50 basis points as of April 20, 2018.
Just how rapidly is the local debt market opening up to foreign investors?
Ho: It appears savvy investors already heard the message about China exposure, if the interest we’ve received from institutional investors recently is any indication. Foreign ownership of China’s relatively lower risk government bond market sector is now approaching close to 6%, having climbed by 2% in approximately the last two years. 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 a 2% to 3% average. Such foreign ownership levels are extremely low compared to most of the other Asian bond markets which range from 10%-40%. This implies there is scope for Chinese bond holdings to increase over time closer to 10%.
What about the currency, isn’t that a concern?
Pang: Renminbi [RMB] internationalisation is continuing to progress on pace. Although the Chinese currency accounts for just 1% of global central bank reserves currently, we expect the government to continue to prioritise stability relative to the US dollar, which we expect to continue to weaken gradually. Whereas dollar strength historically caused investors to see less need for non-USD FX exposure, the cycle appears to be turning. Another factor in China bonds favour – we would expect once prohibitive RMB hedging costs to continue to compress, presuming ongoing capital account liberalisation making such investments potentially attractive even on a hedged basis.
Why should global investors be keen to get involved in Chinese bonds?
Ho: Apart from providing exposure to the world’s second largest economy, RMB bonds look attractive from a macro standpoint as well as a total return perspective.
Chinese domestic bonds offer offshore investors highly competitive yields. Relative to the measly average yield of just 1.8% on the global aggregate bond index, Chinese government bonds offer an attractive 3%-3.5% yield. Chinese bonds also have a low correlation with developed market core rates, making them attractive from an asset diversification perspective.
China bond market’s average credit rating is A+, indicating the market on average offers solid credit quality. Yet the market’s current yield is the third highest in Asia. As measured by return compared to volatility, risk-adjusted returns are attractive and China bond market’s overall volatility profile is on the lower end.
Investing in RMB bonds is hardly a singular universe, as investors can gain access to China issuers in a number of different ways. The challenge and opportunity for investors will be extracting the best possible return for the lowest level of sovereign risk across onshore, offshore (dim sum) and dollar bond markets.
How can investors make money in Chinese bonds? And why should we care about this now?
Pang: We believe the best alpha opportunities in China are in cross-border investment. This means being active across CNY [Chinese yuan/onshore RMB], CNH [offshore RMB] and USD bond markets (hedged into RMB). So far this year, onshore CNY bonds have rallied and may continue to do so given global uncertainty, but CNH bond yields have actually remained higher, suggesting offshore investments offer attractive value for both foreign and domestic investors from a rates arbitrage perspective.
An understandable precondition for exposure to Chinese bonds likely remains understanding and familiarity for many investors, but the reality is that Chinese bonds are rapidly becoming too important to ignore. There is a powerful secular story for this investment, which should be beneficiary of passive flows driven by increasing index inclusion.
