Progress brings opportunities in China bonds

Raymond GUI: Not just last year, but in fact for the past three years, onshore RMB-denominated Chinese government bonds have far exceeded the performance of government bonds in developed markets. China being in a different interest rate cycle from most of developed markets (DMs) is a major factor. To counter high and persistent inflationary pressure in developed markets, the US and Europe raised interest rates several times last year. In contrast, inflation has been well managed in China, and the PBOC was able to cut key interest rates to support growth. As a result, China’s onshore RMB bonds delivered a +4.8% total return in CNY as measured by Bloomberg China Aggregate Index last year while returns of US and European government bonds were negative.

The outperformance was accompanied by low correlation between RMB government bonds and DM government bonds. This welcome by-product, again of divergent interest rate cycles, makes RMB bonds a great addition to global fixed income portfolios for diversification and hedging purposes. Also, the correlation between Chinese bonds and equities is negative, which could serve a multi-asset portfolio well.

It is also worth looking further back in history. Chinese inflation and interest rates have been relatively stable in the past 30 years, effectively holding down bond market volatility. RMB government bonds were not nearly as volatile as DM government bonds, and their inclusion could mitigate the overall volatility of a global portfolio.

On recent foreign flow alongside changing investment horizons

Raymond GUI: Overseas investors have increased their onshore RMB bond holdings since 2020, even though they currently only hold about 3% of the Chinese bond market. We believe this ratio could continue to grow in the medium to long term, as we see signs that foreign strategies are becoming longer term with their China allocation. In contrast to ten years ago, overseas investors are adjusting their allocations but seldom exit the China bond position altogether.

LI Dafu: Precisely because the proportion of Chinese bonds in global portfolios is low, there is plenty of growth potential. There is a lot of work to be done in terms of the internationalization of RMB bonds, but the market is heading in the right direction. Case in point: recent data point to a pick-up in foreign inflow.

A brief history of the China bond market

LI Dafu: The onshore RMB bond market has grown five-fold in the past ten years, which at US$20 trillion (RMB 160 trillion) is the second largest bond market in the world. The sheer size is one marker of success, with the expansion all the more impressive when compared side-by-side with the economy.

Take the ratio of onshore RMB bonds to the overall GDP. Ten years ago, China’s GDP was RMB 60 trillion and the ratio of onshore RMB bonds to GDP was about 50-60%. Fast forward to today and GDP is around RMB 126 trillion; the ratio has reached 125%, demonstrating not only the extraordinary speed in which the China bond market has developed, but also there is still room to grow. (source: National Bureau of Statistics, China, Central Depository and Clearing Co., Ltd., Shanghai Clearing House, Shanghai Stock Exchange, Shenzhen Stock Exchange)

The speed and magnitude of the growth was made possible by significant changes in the country’s financial markets. From only a handful of credit debt issues from state-owned enterprises to a diverse and large group of corporate issues today, there were several pivotal moments in the buildout.

One was the establishment of the bond futures market in 2013. It was a “Zero-to-One” progress that brought about greater diversity and selections in income-generating assets – an important first step in the modernization of the onshore China bond market.

Another was the Bond Connect program in 2017 that gave overseas investors access to Chinese fixed income markets. The monthly settlement amount started at less than RMB 100 billion in the first year and has risen to a RMB 1 trillion peak in 2023, while the custody amount went from less than RMB 1 trillion to RMB 3.3 trillion (source: Hong Kong Exchanges).

Moreover, the inclusion of Chinese bonds in global bond indexes, including Bloomberg-Barclays, JPMorgan and FTSE Russell has brought substantial inflow and further pushed forward the internationalization of the market.

The market has made measurable progress in the past decade, and we think it will continue to grow in the next decade.

OUYANG Kai: The broadening of the overseas institutional investor base has a meaningful impact on the growth of the onshore RMB bond market as well. Central banks, sovereign entities, multinational corporations and asset management companies all have a hand in helping the RMB bond market go international. A data point for reference: the value of bonds held by overseas institutional investors reached RMB 3.5 trillion at the end of November 2023. (source: Wind)

Raymond GUI: The onshore RMB bond market has come a long way. The message behind the changes already mentioned as well as the different programs like QFII, CIBM and Bond Connect is that the market welcomes overseas investors and has worked hard to meet international standards. Trading China bonds today is not much different from trading bonds in other markets; the transaction process and settlement conventions are increasingly similar.

The last thing I want to add here is an obvious change in how the onshore credit market has become more efficient in terms of pricing underlying credit risk. Defaults have taken place in a more market-driven manner in the past few years, which forces investors to put more weight on credit fundamentals as reflected in the yield level. This is a positive development, promoting efficient allocation of financial resources to higher quality and more creditworthy companies.

The outlook of the Chinese economy

OUYANG Kai: Although China’s slowing pace did not meet our expectations, positive changes are on the way given the growth potential of the economy. Firstly, we believe that China-US relations will embark on a new journey. Also, the Federal Reserve is likely to kick off a rate-cutting cycle that could take its target rate down 150 basis points by year-end, in my view. This could significantly reduce the difference between interest rates of China and the US, alleviating the pressure on Chinese rates.

A more proactive and pro-growth policy stance should help relieve some of the bottlenecks in the economy such as real estate and budget deficits, but there are challenges. The Central Economic Work Conference has pointed out insufficient consumer demand, low consumer and business sentiment as well as oversupply in certain industries as inherent risks of an economy transforming itself to focus on consumption and services from manufacturing and exports.

We also see uncertainties from geopolitical conflicts, continued real estate stress, restrictions on land administration policies, and pressure on sovereign bond issuances as additional factors that could prove problematic. From our perspective, if China were to set a 5% GDP growth target for 2024, there needs to be stronger backing from the government with relevant policies that align with the target.

Raymond GUI: We are positive on China’s growth in 2024. Since late last year, more policy stimulus measures have been announced on both fiscal and monetary sides, set to boost growth well into this year. As LI Dafu mentioned earlier, the ratio of government debts to overall GDP is still low in China, compared to developed countries. There is ample room in both fiscal and monetary policies to provide further stimulus if needed.

On the opportunities in the China fixed income market

LI Dafu: The general direction of the market is positive, but the market is moving fast. Because 2023 was a bullish year, return expectations for this year should be appropriately managed. I would caution against buying into crowded trades or assets that are being traded feverishly on the secondary markets. Using 30-year RMB government bonds as an example, trades on these long maturity bonds by non-bank institutions picked up significantly last year and peaked recently because of lofty expectations of an interest rate cut early this year. Besides lowering the bank reserves requirement ratios, the PBOC has not adjusted its key interest rates since last August.

For investment opportunities, I look toward assets with coupons – i.e., credit debt. Tier-2 bonds issued by financial institutions of three-to-five years in maturity, or perpetual bonds within one-to-three years are potentially attractive investments in my opinion. I also like local government bonds from certain provinces and municipalities, which have been popular recently among institutional investors, but you must be selective when choosing maturity and issuer.

That said, it is important to keep these two major risks in mind: the impact from ongoing property market weakness and the overall health of local government debt market. Both could weigh on economic growth if unresolved.

OUYANG Kai: I have similar views and think that the curve of returns is relatively flat. For the medium- to long-term, the ideal inflation rate is about 2%. The return of the 10-year RMB government bonds is currently about 2.5%. If we expect the economy to reach 4-5% this year, I believe RMB bonds with a 10-year maturity are not attractive investments. High grade credit bonds with investment value are more favorable in my view.

Raymond GUI: With a positive outlook of the Chinese economy, our base case for this year is that we may see lower 10-year Chinese government bond yield, due to monetary easing expectations first, and then higher yield later as both fiscal and monetary stimulus starts to take effect. Our approach is to stay flexible on duration and sectors.

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