Where do investors go in a low-yield world? With yields in most developed markets either negative or heading that way, there's probably no more pressing question in the investment world today, particularly as we move into 2020.
Luckily, there remains hope for bond investors and it lies with exploring the full opportunity set offered by what is a deep and diverse global bond universe.
China's onshore bond market has recently come to the fore with inclusion in major global bond indices. It offers a compelling opportunity to complement returns from traditional bond markets and help diversify investors' fixed income exposure. Here are some important reasons investors should take notice:
- Yield: China government bonds offer positive nominal and real yields compared with developed markets, and that's been a standout feature for the past three-to-four years as well as an attractive one in the world economy as it is today.
Head of Asia-Pacific Fixed Income,
UBS Asset Management
Real yields compared (%), Aug 2009-Aug 20191
- Liquidity: China's bond markets overtook Japan as the world's second largest in late 2018. As China reforms its financial sector and continues to develop bond financing channels, the market is expected to continue growing in the coming years.
- Correlation: China bonds have a low correlation to global bond markets so offers a strong diversification benefit. Taking Europe as an example, China has a 0.05 correlation, compared with 0.6 for the US and 0.55 for Japan, so exposure to China bonds can help diversify risk and return sources2.
- Downside protection: Given the higher relative yields and shorter duration profile of the China government bond universe, investors can expect to benefit from smaller drawdowns during periods of rising bond yields compared to other developed markets, adding further to the diversification characteristics of China bonds.
- Safe haven: Chinese government bonds show all the traits you'd expect from safe haven assets and we have seen yields fall during recent bouts of broader market volatility. Importantly, China remains a net creditor nation and has the world's largest FX reserves, so no one will be calling China on its debt.
But despite all these points, investing in China can be a leap for more traditional investors.
In part, that's because China is always in the news cycle and much of the coverage is sensationalist. Here's our view on four of the most common concerns around investing in China.
#1 - China's economy is slowing. Yes, it is slowing – and that's a good thing. China's rapid growth of the past was fueled by unsustainable growth in debt and fixed asset investment. Now, China is committed to deleveraging and has shifted the economy toward the more sustainable growth drivers of consumer demand and services-led growth. This means slower but more sustainable growth for the long-term.
#2 - China has a debt problem. Debt is certainly high, no doubt about it. However, we don't see it as a source of an impending crisis – and there are three main reasons for this. Firstly, China's debt is drawn from one of the world's largest savings pools, so it is domestically, rather than externally, financed, so there's little risk of a balance-of-payments crisis. Secondly, more than half of China's debt is concentrated within state-owned enterprises (SOEs), i.e. within the government and not the private sector. Finally, China still has a lot of growth potential. Unlike the Japan situation in the 1990s, China still has a lot of productivity gains ahead of it, so it has the room to grow its way out of the debt to some extent.
#3 - Investors can't get in or out of China's markets. Not true. Recent index inclusion and the opening of the China Interbank Bond Market Direct and Bond Connect channels means full access to onshore China bond markets, with ready access to investment capital via these channels. We see it very unlikely that China will implement capital controls for foreign investors given its commitment to becoming one of the world's major developed bond markets and in integrating with the global financial system.
#4 - International investors just aren't convinced by China. That, again, is wide off the mark. Official data shows sustained growth in international investors' holdings of onshore China fixed income. In fact, total holdings have tripled since January 2016, and recent trends have seen acceleration, discussed in more detail below.
Overseas Investors' Holding of Onshore Fixed Income in China (RMB Trillions), Jan 2016-Jun 20193
And that fundamental change is the shift in global capital to China as core components of China's onshore bond market are included into major global bond indices.
Bloomberg led the process with inclusion of China treasury and policy bank bonds in its global bond indices at the beginning of April 2019 – and this has now broadened with JP Morgan recently announcing index inclusion plans.
This impacts a wide range of global bond investors as passive (i.e. index) funds that follow these major indices must now invest in China bonds, and active managers must take a view given the major benchmarks will include parts of the China onshore bond market.
This shift is expected to lead to as much USD 500bn of inflows into China's markets from Bloomberg bond index inclusion alone - and this has three important implications.
Firstly, it is happening because the world's biggest index providers have seen China's recent reform efforts and now deem China as 'safe-to-swim'.
Secondly, allocation to China is now going to become a mandatory, not optional, allocation for millions of investors worldwide.
Finally, the massive influx of global investor capital is going to put downward pressure on yields, and that means it is time for investors to take the opportunity and get exposure now, rather than after the chance has passed.
This phenomenon is occurring across more asset classes than just fixed income. MSCI began including China equities in its emerging markets index in 2018. FTSE Russell and S&P Dow Jones have since followed suit, a reflection of China's increased efforts to integrate its capital markets into the global financial system.
The compelling case for China fixed income is one of many opportunities uncovered by actively exploring the global fixed income opportunity set and why it pays to employ a truly global and diversified approach to investing, particularly as we face a world of lower – and increasingly more negative – bond yields