After surpassing $14trn in market capitalisation, more foreign investors are looking towards China’s onshore bond market to identify opportunities and diversify portfolios.
Its allure is far greater than simply being able to access the second largest fixed income market in the world. More specifically, the potential to enhance yield via China bonds is reflected in the notable yield differential between US 10-year Treasuries and the China government bond (CGB) 10-year note; this reached an all-time wide level of 250 basis points (bps) in November 2020, and was around 160 bps as of mid-March 2021.
Another key attribute is the possibility of diversifying portfolio risk. This is based on the relatively low correlation of RMB bonds with other bond markets.
“With yields so low and credit spreads so tight in many global bond markets, RMB bonds offer outstanding value at the moment compared with almost anywhere else,” says Geoffrey Lunt, director and senior fixed income investment specialist at HSBC Asset Management.
Well-timed entry
This backdrop bodes well for those investors wanting to access China’s onshore bond market.
There was already growing awareness of the potential for this asset class in line with the inclusion of Chinese government and quasi-government bonds in the Bloomberg Barclays Global Aggregate Bond Index in 2019. But while this journey is a necessary condition to bring RMB bonds into the mainstream in general, the yield pick-up has offered a timely entry point.
For example, foreign investors, in search for yields, purchased more than $100bn worth of Chinese bonds in 2020. In particular, June, July and August recorded the largest inflows on record.
Investors have also seen the benefit of China bonds being much less correlated with emerging market fixed income more broadly than many people typically think. “The majority of the debt is domestically held, and sits within a relatively closed economy,” explains Lunt. “This results in behaviour more akin to a developed bond markets, limiting outflows due to risk aversion.”
Beyond securities at the sovereign level, some Chinese high quality commercial bank and AAA bonds also offer a decent yield pick-up over government bonds without much increase in credit risk, he adds.
At the same time, the RMB is expected to appreciate against the US dollar amid strong macroeconomic fundamentals, favourable interest rate differentials and a strong foreign demand for Chinese assets. For example, by 2030, HSBC Asset Management forecasts that the RMB could potentially make up 5% to 10% of global reserve assets – translating into an estimated US$3trn flows over the next decade.
A strategic choice
These dynamics point to a five- to 10-year opportunity in China bonds, at least. This, in turn, reinforces the importance of inclusion. “Investors should be looking at China bonds as a long-term strategic asset allocation, not just as a value play,” says Lunt.
This has the potential to benefit foreign investors that look at the long-term secular convergence between Chinese and global interest rates, he explains. “The domestic Chinese economy is clearly expected to remain strong for many years to come, but growth rates are starting to ease, as expected at this stage of the economy’s development.”
China’s policy direction also bodes well for investor demand for RMB bonds. The emphasis on decarbonisation and a green economy during the 2021 National People’s Congress (NPC) in early March, for example, should offer foreign investors some interesting opportunities to build on China’s existing green bond status, explains Lunt.
Further, there is also now a clear emphasis on stability and fostering domestic demand, he adds. “For credit markets, a focus on quality and balanced growth rather than an absolute level of growth is welcomed.”
Navigating local hurdles
Taking the step to invest in China bonds, however, requires some careful planning and consideration.
From a credit ratings perspective, for instance, China onshore bonds are mainly rated by local rating agencies, which have different standards to international ones. “Foreign investors in China would not be able to set their investment guidelines on the basis of domestic ratings only,” says Lunt.
Yet as China continues to liberalise its domestic financial markets, international rating agencies will likely become more involved, therefore leading to better credit differentiation.
For the time being, Lunt is confident in HSBC Asset Management’s expertise and experience in doing the credit research itself, rather than relying on the rating agencies.
Whether to take China bond exposure hedged or unhedged is another common consideration. Lunt says the decision depends on individual preferences.
Investing in RMB bonds on a hedged basis, for instance, doesn’t tend to sacrifice much yield, yet offers good diversification. “This is one of the most compelling reasons to invest in China bonds,” he adds. Other investors, meanwhile, might opt for unhedged exposure, especially if they are bullish on the RMB, or think US dollar weakness is on the horizon.
There are also defaults to consider. These picked up pace in late 2020 in the onshore credit market, with 25 incidents in total for the year. This compares with 36 new defaults in 2019 and 38 in 2019.
However, this trend also points to policy normalisation alongside the process of a credit clean-up – positive trends for further credit differentiation going forward, as far as Lunt is concerned. “The regulatory measures taken since a few defaults in the state-owned enterprise space are examples of policy objectives at play, making sure of no massive debt evasion.” Looking ahead, HSBC Asset Management expects a steady rise in smaller defaults and increased repayment stress in the state-owned space.
Knowing where to look
To capitalise on the scope and scale of the market opportunity requires holistic coverage, explains Lunt.
This goes beyond a blend of cross-market views (by assessing valuations across onshore and offshore markets) and an understanding of China domestic rates (from macro drivers and policy direction). It also relies on investors being aware of the potential consequences of their decisions by seeing different scenarios.
As one of the largest investors in global fixed income markets, HSBC Asset Management practices a bottom-up credit process which is designed to systematically avoid default risk and credit deterioration. Our RMB strategy has demonstrated consistent outperformance over market indices and is rated 1st quartile over a three-month and year-to-date basis by Morningstar (20/3/2021).
More broadly, as of 31 December 2020, HSBC Asset Management expanded its assets under management in Asia fixed income by 18% from a year earlier to $71bn, including $3.84bn in onshore and offshore RMB fixed income strategies.
“We bring this longevity and experience in investing in fixed income assets globally to the relatively new frontier of China,” adds Lunt.
Applying this gives the firm a certain perspective on different opportunities in China bonds to pursue. These include:
- In the onshore CNY market, for example, it expects a stable growth in net supply in 2021 on the back of a less hawkish policy stance on a resurgence of Covid-19 cases domestically, uncertainty over the global pandemic and the strength of the RMB
- In the US dollar credit market, it expects net issuance to moderate in 2021, with a noticeable drop in new supply from property developers because of tighter regulations
- In the CNH space, it expects higher issuance thanks to the strong performance of the RMB and the recovery of the Chinese economy
For more information go to: https://www.assetmanagement.hsbc.com.hk/en/intermediary
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