Conversation with Kevin Zhao — China fixed income: too big to ignore?

What is the benefit of China onshore fixed income having lower correlation to other global markets? Is lower correlation expected to last?

The main benefits of including additional countries or assets to portfolios which have low correction with existing bond markets, are diversification and relative value opportunities.

We think over the next few years this low correction will stay for two major reasons; firstly, China stopped pegging its currency to the USD in 2005 and subsequently moved to a basket basis in 2016, which allowed China's monetary policy to diverge from the US and other G7 countries. Secondly, unlike central banks in G7 countries that have cut their policy rates to near zero or even negative in some cases and engaged in a variety of unconventional monetary policy measures in 2020, the Chinese central bank (PBoC), has been more cautious. It has ample room to cut rates if the economic outlook is much worse than expected.

Since the inclusion of Chinese bonds in the Bloomberg Global Aggregate, JPM GBI-EM and WGBI extended indices, foreign participation in China's onshore bond markets has risen significantly. In addition, many central banks have purchased Chinese government bonds since China's inclusion in the IMF’s (International Monetary Fund) SDR basket in 2016. In turn, this has resulted in a diversified pool of foreign investors alongside domestic buyers.

What can investors expect from the inclusion of Chinese bonds in global bond indices?

Once China's weight in global bond indices rises to around 6%,  investors, especially in global bonds, should be able to enhance portfolio returns as a result of the size of the opportunity set and the relatively low correlation that Chinese bonds have to other bond markets. However, investors must be familiar with China's economy and financial market structures; as we often say, "do your homework". UBS AM has been very early and proactive in entering China's equity and bond markets with a leading presence among foreign banks and asset managers. It is important for investors to understand that China is not a typical EM market nor should investors apply their experience and skills learnt from developed markets blindly to investment in China given drastically different political, economic and financial systems.

How important are emerging markets, and China in particular, in a global portfolio?      

We have been very vocal that the "New Global" is the G20 rather than the narrowly focused G7. G20 countries account for more than 80% of global GDP, trade, and financial asset capitalization, while G7 accounts for less than 45% of global GDP. China is already the second largest bond market in the world¹, but it had zero representation in the bellwether Global Aggregate Bond Index before Bloomberg decided to include the country in April 2019. China's weight in this widely followed global bond index will rise to around 6% by the end of 2020². We believe that broadening bond investment from G7 to G20 countries will allow investors to achieve higher potential returns and better diversify portfolio risks.  

¹Bank of International Settlements, December 2019

²Wind, March 2020