China fixed income – investing in a new world

China's fixed income markets are integrating with the global economy and opening up a new world for global bond investors.

08 Jun 2020

In this new report, we examine the investment case for China fixed income and show what an allocation to China bonds can do for global investors' portfolios.

China fixed income – investing in a new world: key takeaways

  • In a world where yields are turning negative and bond markets are becoming more volatile, China's onshore fixed income markets are an attractive option for investors;
  • Offering attractive yields, low correlation, safe haven properties and hedging costs so far in 2020, China bonds have a strong investment case;
  • China bonds also offer strategic, long-term exposure to long-term megatrends in China such as the rise of the RMB as a reserve currency, the growth of China's pension industry, and China's rising status as one of the world's largest economies

Fixed income investors are entering a new world.

And it’s a world of negative yields. Central banks' quantitative easing has driven a 36% average y-o-y increase in negative yielding debt over the past five years to reach USD 11 trillion at the end of March 2020.

Market cap of positive and negative yielding debt on global markets (USD billions), Feb 2012-Feb 2020

Source: Bloomberg, Bloomberg Barclays Global Aggregate Index MV USD. As of end February 2020

This new world is considerably more volatile - and correlated - than before. Global economic uncertainty has pushed annualised volatility of some developed country bonds to double-digit levels.

Global Bond Aggregates 1 yr rolling weekly volatility, Apr 2016-Apr 2020

Source: Bloomberg, Apr 30, 2020

And investors are in a new world where China is much more influential. China's steady integration into the global financial system is opening new territory to bond investors.

Given the challenges of negative yields and rising volatility, there's a strong investment case for China onshore fixed income - particularly in the government and policy bank sectors - because of the following five key factors:

  • Attractive yields: China bonds offer superior yields against most global government bond benchmarks, and we expect this to continue to be the case given the differences in China's monetary policy regime;
  • Low volatility: China's bond markets have been markedly less volatile than global markets: largely because the domestic market is dominated by domestic investors and the banking sector holds a large part of the bond market – two factors which are unlikely to change in the near-term;
  • Low correlation: offering diversification benefits against global asset benchmarks. China's economy and policy cycles are not directly influenced by Fed policies or volatility in the US banking sector volatility, as in other western economies.

    After USD global currency status ascended since the 50's, so did its influence over other western financial markets. China's capital markets have largely been immune to US policy action as they're self-funded as one of the largest creditor nations in the world. Their domestic capital market has low foreign ownership, so correlation vs. global markets is also low, and will likely remain so;
  • Safe haven properties: China government bonds have performed well during periods of volatility, which suggest they have potential to serve as a safe haven asset for global investors;
  • Historically low hedging costs: the cost of hedging into CNY is at historical lows, so now might be a good time for investors to take advantage.

But for all of China's progress, challenges still remain. Investors need to navigate the nuances of China's corporate structures, linkages to the state and liquidity in credit markets. As the credit markets will evolve rapidly we caution new investors to seek out solutions that offer interest rate sensitivity and take advantage of the defensive characteristics that are in short supply globally today.

Challenges like this reinforce the value proposition of local expertise and deep networks across China's financial markets. We believe that an established China presence can help cut through the noise surrounding China and position investors for the best opportunities.

And that's going to be valuable going forward. Yes, the current investment case is strong, but three megatrends described here - the rise of the RMB as a reserve currency, demographic change and the growth of China's pension industry, and China's rising status as one of the world's largest economies - will make positioning in China an essential part of global asset allocation strategy in the future.