At more than USD 15 trillion, the Chinese bond market is the second largest in the world. China only has to surpass the United States. China is therefore the second-largest economy in the world and the Chinese economy is already almost 20% larger than the United States in purchasing power parity terms. Yet many investors outside China hardly have any positions in Chinese bonds.
This while, at this time, there is a high added value, both in terms of return and diversification in a broadly diversified bond portfolio.
Distinction between investment grade and high yield
In China, it is a good idea to make a distinction between the Chinese investment grade (government) bond market and the Chinese high-yield market. The high yield market consists mainly of bonds of property developers and, as a result of the situation surrounding Evergrande and some other property developers, credit spreads are at their highest in years.
The contrast with high yield outside China could not be greater and, although such a crisis in high yield usually turns out to be a good opportunity to invest, Chinese investment grade (government) bonds are particularly attractive to foreign investors. The high-yield market in China is relatively young and, thanks to Evergrande, is learning a wise moral hazard lesson. Not so long ago, the Chinese government still served as the guarantor for every Chinese company that could not meet its obligations, but those days are over.
The fact that not every company automatically receives a bailout from the Chinese government is good for Chinese government bonds and for the Renminbi. High yield is usually only a small part of a bond portfolio. The real problem for investors is low or even negative interest rates on government bonds. The bulk of a bond portfolio consists of this type of government bonds and Chinese government bonds offer an alternative in several respects.
Chinese bonds included in indices
It has not always been easy for foreign investors to buy Chinese bonds, but things have improved in the past five years. The QFII/RQFII quotas are now gone and foreigners can trade directly in the domestic bond market. The Bloomberg Barclays Global Aggregate Bond Index and the JP Morgan GBI-EM Global Diversified Index have been taking Chinese bonds since 2019 and 2020. From this month, Chinese bonds will also become part of the FTSE World Government Bond index with a target weight of 5.25 per cent. This inclusion will be spread over 36 months, but with as much as USD 1.5 trillion invested according to this index, this alone means that about USD 2 billion more is flowing into this market every month.
Last year, more than 1 trillion Renminbi ($155 billion) in foreign assets flowed into the Chinese bond market and foreign assets now total 3.3 trillion Renminbi. This is expected to increase due to its rising weight in various indices. The fact that Chinese bonds are part of these large indices also means that active investors have to think about them. As a result, there is more focus on the fundamentals of the Chinese bond market.
Don’t fight the PBoC
First, the Chinese bond market has an important function in the internationalisation of the Renminbi. Arabs and Russians are happy to be paid in Renminbi, provided they can store it somewhere. Just as China can only hold all earned dollars in Treasuries, these countries are now buying CGBs (China Government Bonds). The interest rate on a ten-year Chinese government bond is now just over 3%, about twice as much as the US ten-year rate.
Taking into account inflation in China, the difference is even greater. In China, there is a positive real interest rate of 1.8%, whereas in the United States, the real interest rate has become extremely negative due to high inflation. This high Chinese real interest rate is due to the policy of the PBoC, which in many ways resembles the old Bundesbank. Chinese bankers, like German bankers, have an aversion to inflation. In Germany this is rooted in the destruction of the German middle class in the hyperinflation of 100 years ago, in China it is based on Marx’s inflation warnings.
Inflation can disrupt a society and that is the last thing those in power in Beijing want. That is why China has no quantitative easing or negative interest rates, no monetary hocus-pocus. In that respect, it is strange that Chinese interest rates are still above American interest rates. In this respect, a comparison can be made with German interest rates. At the end of the 1960s it was also above US interest rates. Ten years later, German interest rates were far below American interest rates. At the end of the 1960s there were still four Deutschmarks in a dollar, ten years later there were less than two. The result: a superior return on German bunds versus US Treasuries. History doesn’t repeat itself, but it often rhymes.
The safe haven of Chinese Renminbi
The PBoC’s policy also ensures relatively low volatility. Those buying Chinese bonds (and not hedging the currency) get about twice the return of a global bond portfolio, but only with 92 per cent of the volatility. Chinese bonds will therefore increasingly be seen as a safe haven in times of turmoil. In the first quarter of 2020 during the sell-off in equity markets, the yield on Chinese government bonds stood at 1.8 per cent, compared with 2 per cent for global investment grade bonds and - 13.4 per cent for Emerging Debt.
The sell-off in US Treasuries early this year also bypassed the Chinese bond market. Ultimately, of course, it is about the fundamentals of the Chinese economy. There is often talk of Chinese debt rising too fast, but the size of the debt is only relevant when set against the economy. Compared to many other large countries, China is still growing fast. This quarter, Evergrande and the energy shortage will also depress growth in China, but this is a temporary effect. Thanks to the strong Chinese currency (even stronger than the dollar), inflation remains under control. The PBoC also has enough room to inject more liquidity into the market, which ensures financial stability. Part of the return in the coming years will come from the steady appreciation of the renminbi, so that the total return on these bonds will even compete with that on equities.
Portfolio weight
The big question for a bond investor is what proportion of the portfolio should be held in Renminbi bonds. Based on the weight in the various world indices, it is about 5%, less than that means an active choice to underweight these bonds. Given the fundamentals, that seems unwise.
That weight is rising. Anyone adding Chinese bonds to a global bond portfolio will see, based on historical data, that the optimum point is an addition of around 50 per cent. Then the portfolio risk is minimised and there is nevertheless a higher portfolio return than with lower allocations.
Similarly, an emerging debt portfolio should even consist of 80 per cent Chinese Renminbi bonds. Actually, given the low interest rates in the developed world and the monetary madness of the larger central banks outside China, it is surprising that nobody allocates so much to China, but perhaps I am now short-changing some Asian investors. Where 5% sounds like little and 50% or 80% sounds like a lot, the truth lies somewhere in the middle. A weighting that does more justice to China’s importance in the global economy seems appropriate to me.
Han Dieperink is an independent investor, consultant and knowledge expert for Fondsnieuws, Investment Officer Luxembourg’s sister publication. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is currently active as chief commercial officer at Auréus Asset Management. Dieperink provides his analysis and commentary on the economy and markets. His contributions appear in Dutch on Fondsnieuws on Tuesdays and Thursdays and from time to time in English on Investment Officer Luxembourg.