Why invest in both Chinese rates and credits
As China’s growth momentum picks up, is it a good time to invest in China again? Our China fixed income team believe so; they point to a combination of onshore government bonds and corporate bonds as the answer.
Raymond Gui
China’s reopening has been underway since late last year, and the recovery is helped by the government’s prioritization of economic growth and accommodative fiscal and monetary stance. However, current sentiment in Chinese bond markets is somewhat downbeat which, in our view, overlooks the bigger picture and longer-term potential.
Will market confidence return? We continue to see investment opportunities in China onshore government bonds, as well as onshore and offshore corporate bonds. In fact, a combination of China rates and credit could generate attractive risk-adjusted yields for investors and could bring diversification benefits into a global portfolio.
Expanding domestic consumption and driving a steady and broad-based economic recovery are China’s immediate priorities, reiterated at the National People’s Congress (NPC) last month. This revived growth focus and clear policy direction support our constructive long-term outlook for China, despite a volatile market backdrop (in part due to a hawkish US Federal Reserve and still high inflation in developed markets). Concerns over the health of the global banking sector further intensified market jitters, but the knock-on impact to Chinese state owned banks or Hong Kong banks – with better quality in assets, capital ratio, liquidity and risk management – appear limited.
Chart 1 : China’s economy could outpace Europe and the US
Real GDP growth, in %, including UBS forecasts
Source: UBS. Data as of February 2023.
China’s economy will likely outperform Europe and the US in 2023.
There is potential for a strong rebound for China’s economy in 2023. Our estimates predict it will outperform Europe and the US as both economies face recession risks (see chart above). Faster than expected consumption and manufacturing activities are offsetting the slowdown in exports and driving the recovery, as day-to-day traffic returned (see chart below) and domestic travel over the Chinese New Year holidays recorded the strongest visitor and revenue levels since the pandemic. Latest PMI manufacturing and services data from March also showed the recovery is gaining traction. The positive trajectory should continue in the coming months, eventually leading to a broader and stronger economic recovery.
Chart 2 : Mobility data point to increasing activity
Subway ridership (29 city 7d moving avg.)
Source: Bloomberg, UBS, as of February 2023.
Day-to-day traffic, as represented by subway ridership, has returned, pointing to a positive recovery trajectory for China.
Onshore Chinese yuan (CNY) denominated Chinese government bonds have sold off since last November across the yield curve on the back of reopening expectations and stronger-than-expected recovery data. However, we are still constructive on the fast-growing asset class.
It has not been an easy environment for onshore China bonds. As monetary policies of major economies diverged, developed market sovereign yields are now meaningfully higher and spreads wider than a year ago. This has resulted in the yield advantage becoming less appealing in the near term.
Over the longer term, however, we are constructive on the diversification benefit of onshore China bonds. Looking back, they have delivered steady returns in the past three years, compared to losses of major developed market counterparts. Looking ahead, we do not expect a sharp sell-off because onshore China bonds remain attractive for carry. And since global investors are still meaningfully underallocated in China, they can act as a useful diversifier thanks to relatively stable yields and low correlations to other key global asset classes.
A low correlation to global fixed income and equities means onshore Chinese government bonds are resilient against elevated bond market volatility. The longer term correlation between US Treasury and Chinese onshore rates has been falling over the past five years. And in recent periods, the link has dropped close to zero.
On the other hand, China’s recovery can be a major driver for the performance of Chinese credit – i.e., onshore CNY denominated and offshore USD denominated corporate bonds.
In real estate, policy remains accommodative for the sector. Measures announced early in the year to support property developers and stimulate housing demand had a stabilizing effect. Recent news reports of private equity funds potentially being able to invest in the residential housing market also supported sentiment.
Notably, sales from the top 100 property developers recorded a significant increase in sales that beat market expectations in March. And data on mortgage loans showed ample availability, with the quickest loan disbursements in recent months. Home prices also ticked up for the first time in more than a year and a half in February.
While it is too early to call an end to the sector’s volatility and diligent risk-reward analysis on a developer-by-developer basis is always key, recent developments appear encouraging. New offshore bond issuances from real estate developers also offer some indications that the funding for the sector is returning. We believe select Chinese credits are well supported from a fundamental perspective and may continue to outperform the rest of Asia this year.
It is also worth pointing out that even as the property sector stabilizes, it no longer has an outsized impact on the broader Asian credit market. Chinese real estate now makes up a smaller proportion in various related APAC benchmarks. This structural change is apparent with JPMorgan Asia Credit High Yield Index (JACI HY Index): The real estate sector currently stands at 23% of the index, in strong contrast to the 43% from three years ago (see chart below). Exposure to China has also dropped from 53% to 30% during the same period.
Chart 3 : Structural changes in Asia high yield market
China property sector is now a smaller part of JACI HY Index
By Country
Source: JPMorgan. As of January 2023.
Chinese real estate no longer has an outsized impact on the broader Asian credit market, as it makes up for a smaller proportion in various related APAC benchmarks.
By Sector
Source: JPMorgan. As of January 2023.
Chinese real estate no longer has an outsized impact on the broader Asian credit market, as it makes up for a smaller proportion in various related APAC benchmarks.
Chinese credit – including the real estate sector – took a breather recently after strongly rallying since last November. While recession scenarios in Europe and the US could bring more volatility in credit spreads, in a deep recession scenario a rally in US Treasuries could help to partially mitigate credit spreads widening, especially in investment grade.
We remain constructive on Chinese credits; in particular to sectors that can benefit from the China reopening theme. Besides real estate, they include technology, financials, consumers-related and Macau gaming bonds.
We see benefits offered by both onshore CNY denominated China government bonds and onshore CNY denominated and offshore USD denominated corporate bonds. Since the asset classes often have an inverse relationship, a flexible allocation between interest rates and credit could make sense.
In general terms, when an economy improves, interest rates on government bonds rise and interest rates on corporate bonds fall. When an economy deteriorates, corporate bonds become riskier and interest rates on them rise. Investors seeking havens buy government bonds and their interest rates fall.
Case in point: Last year was a selloff year, and rates markets outperformed while credit underperformed. Therefore, under improving economic conditions—which are what we are seeing in China—investors could do well allocating less duration to CNY rates and more risk to Chinese credits.
There is also a relative value opportunity between China’s onshore and offshore credit markets that can be exploited. On currency hedged basis, for the same Chinese issuer and tenor, some offshore USD denominated high yield bonds are traded at a yield premium of 2% or more against onshore CNY denominated bonds, while some onshore CNY denominated investment grade bonds are also traded at a yield premium against offshore USD denominated bonds. In addition, the low correlation between onshore government bond and offshore credit markets is favorable for alpha generation through tactical asset allocation.
The economy of hedging between CNY and USD has been dynamically changed due to the interest rate differential between China and the US. Currently for US dollar investors, hedging CNY generates a yield pickup of about 2.5% in USD terms.
Overall, we believe a combination of Chinese rates and credits can be greater than the sum of their parts, and striking the right balance can present an investment opportunity. Higher potential yields and low correlation to developed markets offer great diversification benefits. China fixed income continues to be a solution for global investors to capitalize on the country’s long-term growth story.
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