David Cheng, Investment Director, Fixed Income
The economic fallout from Covid-19 has, if anything, further highlighted the attractiveness of the Chinese government and corporate bond markets and the role that Chinese bonds can play within an investor’s portfolio.
China fixed income performed relatively well during the Covid-19 market downturn earlier in 2020. Chinese government bonds provided investors with the risk hedging benefits of a defensive asset whilst onshore Chinese corporate bonds were one of the only major credit markets to provide positive returns during this period.
We take a closer look at the China fixed income market and outline six reasons why it looks attractive.
First, absolute yields on China’s onshore bonds are trading at their most compelling levels relative to global developed market sovereigns. We believe China government bonds at around 3.25% offer an asymmetric return profile for investors, with limited downside but potential for price appreciation. China government bonds are at their widest spread levels versus global sovereigns over the past 10 years, thanks to the strength of the Chinese economic recovery from the pandemic.
Also, the fact that Japanese and German bonds failed to provide downside protection in the first quarter of 2020 suggests that the role of the traditional bond markets as defensive assets in the next downturn may be limited when yields are at zero percent. This makes China’s government bonds a compelling alternative as a high-quality defensive asset for many investors.
Chinese corporate bonds also boast attractive yields and wider spreads with lower duration risks than other global credit markets. The investment grade market has delivered relatively steady performance over the last five years. In today’s historic low interest rate environment, this additional income and carry benefit could prove to be even more valuable for investors.
China is expected to be the only major economy to generate positive GDP growth in 2020 as it successfully rebounds from the pandemic slump. Inflation remains subdued as global demand has stayed weak. This favourable dynamic of positive growth with low inflation has provided the People's Bank of China with more flexibility in its monetary policy, allowing it to more effectively support Chinese companies.
China’s corporate bond market has limited exposure to oil and gas and hospitality sectors, and greater exposure to state-owned enterprises supported by the government, as well as domestically driven sectors, with the property sector that seeing continuing favourable fundamental demand. This makes the China corporate bond market less sensitive than most other credit markets to the ongoing Covid-19 shock.
While China’s bond default rates have risen in 2020, along with those of global credit markets, they have been more concentrated in select industrial issuers. We expect the combination of policy support, steady economic growth, and a more favourable market structure to lead to lower corporate default rates than those of other global companies.
The mainly domestically held bond market differentiates China’s market structure from most other emerging markets that are more vulnerable to the volatility of global capital flows and external funding pressure.
The continued global bond index inclusion of China bonds and the further internationalisation of the renminbi are both positive tailwinds for China bonds. In fact, by August 2020, year to date flows into China’s onshore fixed income market had already exceeded the total annual flows seen in any previous years in its history, highlighting the strength of global investor demand.
We believe the US dollar is on a structural weakening trend due to its large twin deficits and unlimited quantitative easing (QE) programs.
China’s expanding economic outperformance, high rate differentials against major economies, improved current account, portfolio inflows, as well as pent-up demand for global investors to diversify away from the US dollar should justify a stronger yuan going forward.
We expect onshore Chinese bonds to remain a unique asset class exhibiting low correlation to global markets. Why? The Chinese economic transition to a more domestic consumer driven market has been accelerated by both the US trade tensions and the rise of the Chinese middle class.
This domestic focus and “decoupling” from the US would suggest that China’s economic and monetary policy cycles may not be perfectly synchronized with other parts of the world, leading to lower correlations of Chinese assets with other markets. The fact that we are seeing People's Bank of China take a more measured approach in its monetary policy than most developed markets is an example of this.
We expect the favourable risk-return profile, attractive valuations and the diversification benefits to persist for China’s fixed income market. It’s hard to ignore this very large market, especially against a backdrop of lower interest rates and higher volatilities globally.
China’s bond market could be the defensive asset class that provides both the return potential and the downside protection that investors are searching for.
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